Chinese President Hu Jintao arrived in Russia on June 16 to attend the St. Petersburg International Economic Forum, one of Russia's largest annual economic conferences. At the conference, Hu will meet with Russian President Dmitri Medvedev and sign a long-awaited, significant oil deal. Russia is one of the world's largest energy producers and China is one of the biggest consumers, but these bordering countries have done very little energy trade. Instead, Russia relies mostly on the West as a consumer — it supplies one quarter of Europe's energy — while China largely relies on energy supplies from the Middle East and Africa imported via sea routes. The reason for this disconnect is that Russia's current oil and natural gas production occurs mostly in the west of the country, while most of China's population is in its east, leaving thousands of kilometers between the source and the consumers. The distance — and therefore investment — involved in connecting Russia's energy to China's population is massive. (click here to enlarge image) However, both countries have been reassessing their energy policies. Russia is looking to find energy customers other than Europe. For years, Moscow has watched Europe discuss diversifying its energy supplies away from Russia, mainly for strategic reasons. The Europeans have not made much progress on the matter, but Russia is thinking in the long term and wants to have other consumers lined up. China, meanwhile, is considering the security risks involved in relying on its sea lanes, which are surrounded by competing powers, for energy imports. Beijing already has started diversifying its imports toward land routes by making energy connections in Central Asia. China has newly built oil, oil product and natural gas links to Kazakhstan, Uzbekistan and Turkmenistan. Initially, this sparked competition between China and Russia in Central Asia, since Russia considers Central Asia its territory. However, in the past year, Russia has viewed the connections as a way to get involved in providing China's energy supplies; Russia has gained control of some strategic oil infrastructure within Kazakhstan, including the oil products pipeline that connects to China, the refinery for that pipeline and sections of the Kazakh-Chinese oil pipeline. And now, Moscow and Beijing are looking to tap into each other's markets directly.

Oil Supplies

The oil deal set to be finalized and signed in St. Petersburg was actually made in 2003 but has been under debate ever since. Currently, Russia provides oil to China by rail and pipeline. The first phase of the pipeline, the Eastern Siberia Pacific Ocean (ESPO) pipeline, was completed in 2009, running across Russia from Taishet to Skovorodino and then to the Russian port of Kozmino. This allows Russia to export via ship to China (or other consumers). In November 2010, a spur line from Skovorodino down to Daqing in China was completed, directly sending another 300,000 barrels per day (bpd). Russia also sends 300,000 bpd by pipeline and rail to Kozmino, where it then goes to China via rail and tanker. (click here to enlarge image) According to the current agreement, Russia is to increase the oil supplies sent to China via pipeline to more than 1 million bpd by late 2011, then to 1.6 million bpd by 2014 when the second line of ESPO is completed. But recently Moscow refused to fulfill this agreement and threatened to cut current supplies because of a disagreement with China over transit tariffs. Beijing did not agree to the oil tariffs charged by Russian oil and pipeline companies Rosneft and Transneft. Russia charges a flat transit tariff rather than one based on how far the oil supplies travel. Beijing wanted a tariff break for the oil coming down the spur of ESPO from Skovorodino to Daqing compared to the price of Skovorodino to Kozmino (the spur at Skovorodino travels 60 kilometers, or 37 miles, down to the Chinese border, while the line from Skovorodino to Kozmino is 2,046 kilometers). But this is not how Transneft does business with any company or country. Transneft and Rosneft argue that China owed them $100 million and $127 million, respectively, in penalties. Ahead of Hu's visit, China conceded, and China National Petroleum Corp. has started to pay the penalties and agreed to the flat tariff rate. Russia currently produces 10.2 million bpd and exports approximately 5 million bpd, mainly to the West and its former Soviet states. Diversifying at least 10 percent of Russia's exports away from the consumer market in the West is a start to Russia's overall plan to find new markets. This would account for approximately 10 percent of China's oil consumption, though estimates vary, and would further Beijing's cause of easing its dependency on Middle Eastern and African energy sources.

Natural Gas

Natural gas deals are far more difficult to strike between Russia and China than oil deals. First, the natural gas-producing fields are farther away than the oil fields supplying ESPO. Second, there is no natural gas infrastructure in place connecting the two countries, so it would have to be built. And third, price is a major point of contention between Russia and China. Currently, China is not a major natural gas consumer; natural gas makes up approximately 4 percent of China's total energy mix. But natural gas usage has been increasing rapidly, and China expects its annual consumption to rise from the current 109 billion cubic meters (bcm) to 240 bcm by 2015 to reduce reliance on coal. There is a proposal for the construction of two pipelines that would run from Russia's natural gas regions in the north near the Yamal Peninsula (and eventually from Yamal itself) and from new fields being developed in East Siberia. Should these lines be built, they could transport some 68 bcm from Russia to China annually, increasing Russia's total exports of 152 bcm per year by a third. The first pipeline is the Altai Gas Pipeline, which would stretch 2,800 kilometers from the Urengoi and Nadum fields to the Kanas Pass that goes into China between Mongolia and Kazakhstan. There is already a pipeline running along most of this route, but it carries supplies for domestic Russian consumption. Construction on the Altai pipeline is expected to start in early July, STRATFOR sources in Moscow have said, and be completed by 2015 at the earliest. If the Altai pipeline is built, it will carry approximately 30 bcm and hook into China's West-East pipeline, which connects to China's natural gas-producing region in Xinjiang and is being expanded. But there is a problem with this plan, as the Central Asians are already contracted to fill the West-East pipeline's expanded trunks. China built an intricate network in Central Asia from Turkmenistan, Uzbekistan and Kazakhstan in order to take 30-60 bcm in the future. This plan conflicts with the Russo-Chinese plan for the Altai natural gas pipeline. (click here to enlarge image) The second Russo-Chinese natural gas pipeline is currently called the Eastern Pipeline and is planned to run parallel to the nearly 5,000-kilometer ESPO, carrying 38 bcm of natural gas per year. The Eastern Pipeline can then connect into China via three spurs at Blagoveshchensk, Dalnerechensk and Vladivostok. The Eastern Pipeline is dependent on the development of two large natural gas fields — Kovykta and Chayandin. A handful of small natural gas fields are already under production in Siberia, but Kovykta and Chayandin are massive, with 2 trillion cubic meters and 1.2 trillion cubic meters of estimated reserves, respectively. Chayandin is currently under development and is supposed to be operating by 2016, producing 25 bcm per year. Development has not started at Kovykta, which is an incredibly difficult field that will require foreign assistance to develop. Constructing the infrastructure in Russia alone will require not only nearly 8,000 kilometers of pipeline but also heavy investment in increasing natural gas production. This could mean hundreds of billions of dollars, which Russia could provide if it wanted to spend all the money it has been saving for years, or it could attempt to attract investment from somewhere else. Naturally, China — and even South Korea — could contribute, though China would need to focus on building its own natural gas infrastructure and ensuring distribution to consumption centers. The next problem is price. Russia wants to charge China what it charges Europe — $300-$450 per thousand cubic meters (tcm). Russia asserts that this would bring in $700 billion over the next 30 years. This might seem like a lot of money, but considering the construction and production costs, it could amount to a small profit for Moscow. The Chinese, meanwhile, do not want to pay more than $250 per tcm, which would not cover the cost of construction and production. China is demanding a lower price for numerous reasons: It knows it will have to invest a lot in building infrastructure, it feels it has leverage because its natural gas consumption is fairly low, and it wants to offset the strategic vulnerabilities that will come from reliance on Russian natural gas. These issues have made the negotiations incredibly difficult. Some progress occurred over the past few weeks, in that China began discussing investing in the Chayandin natural gas field, and the routes for the Altai and Eastern pipelines were chosen. However, the two countries have yet to strike a set of formal deals. This is what Hu is expected to accomplish during his trip. Considering the difficulties involved in the natural gas projects linking Russia and China, the projects might make no economic sense. However, this is not only about economics. Beijing and Moscow have many political, security and other issues in their overlapping and respective regions. It could be that energy cooperation, even at a high price, is considered mutually strategically necessary, or it could be a tradeoff for concessions in other areas. It is not clear what the tradeoff could be, but it is clear that a serious discussion is going on between the two Asian giants on finding common ground and shaping a stronger relationship in the future.