China’s Energy Security Achilles Heel

While recent turbulence in the Chinese economy has caused investors and pundits much concern, observers may be missing another critical threat to both Chinese and world markets. Soaring Chinese oil consumption and turmoil in the Middle East have been central, and seemingly irrevocable, features of the global energy landscape in recent years. But China’s outsized and growing reliance on crude oil imports from this increasingly turbulent region leave the world’s largest crude importer highly exposed to the adverse effects of a major supply disruption. The Middle East’s precarious security situation and fragile political balance constitute serious threats to China’s energy security and, by extension, the stability of global markets.

China is thirsty for crude oil. The world’s most populous country consumed over 11 million barrels per day (mbd) and accounted for over one third of global oil demand growth last year. It is reliant on imports for 60 percent of its crude oil needs, and that reliance is growing as China’s demand growth has outpaced the country’s lagging domestic production growth. While the “new normal” rate of economic growth in China is expected to cut into crude oil demand growth, Chinese consumption is still projected to exceed 13 mbd by 2020. This sustained demand growth ensures that China will remain one of the largest and most sought-after crude oil markets on the planet, with suppliers from Caracas to Moscow jockeying to increase their market share in the Middle Kingdom. Despite the best efforts of producers like Russia, China will continue to be disproportionately reliant on imports from the Middle East. In 2014, Middle Eastern crude accounted for over half of total Chinese imports, a share that is unlikely to decrease in a meaningful way given current market trends.

When Saudi Arabia decided in November 2014 to protect market share rather than cut production in the face of falling prices, it effectively set into motion a supply side arms race in which Middle Eastern producers began pumping crude at breakneck rates. This summer, Iraq produced record-high volumes of crude and Gulf Arab OPEC production surged to the highest levels on record, with Saudi production peaking at roughly 10.6 mbd. Even as resilient U.S. shale production and lagging demand growth sent prices tumbling again this summer, Saudi Arabia has been steadfast in its refusal to cut production and cede market share to geopolitical rivals like Russia and Iran. Absent an unlikely Saudi production cut, other Middle Eastern suppliers like Iraq must also continue producing at breakneck rates to protect their market share.

The Chinese market’s strategic importance to competing Middle Eastern producers will incentivize them to maintain or expand current export levels to the People’s Republic. Likewise, China has a commercial interest in importing Middle Eastern oil as many of its refiners prefer Gulf producers’ medium and heavy grade crudes. In short, China will find itself locked in the embrace of Middle Eastern producers for the foreseeable future.

China’s heightened dependence on Middle Eastern crude leaves its import market vulnerable to the region’s various threats, chiefly the Islamic State (ISIS), factional tensions stemming from weak governance, and potential commercial fallout from ongoing political uncertainty. Unrest caused by ISIS is already impacting China’s key Iraqi and Saudi suppliers. In Iraq, ISIS set fire to wells at the Ajil oil field, held the Baiji refinery north of Tikrit, and attacked pipelines to Turkey. The group currently operates in the country’s north and west, a best-case scenario given that the Shia-dominated south comprises 90 percent of Iraq’s oil production and 85 percent of its exports. However, oil majors including BP and ExxonMobil have evacuated employees from facilities in anticipation of future threats, and a diverted security presence has seen a rise in attacks and kidnappings of southern oil workers.

In neighboring Saudi Arabia, China’s largest supplier of crude oil, ISIS aims to foment sectarian unrest in the Sunni Kingdom’s oil-rich Eastern Province. The Shia-dominated province is critical to Saudi production and has been the target of attacks in the past, including the 2006 attempted al-Qaeda bombing at the Abqaiq processing facility, through which an estimated 70 percent of Saudi crude exports pass. ISIS carried out a deadly mass shooting in the Eastern Province in November, targeted Shia mosques for suicide bombings during Ramadan, and the bombing of a Riyadh security checkpoint spurred a massive crackdown by Saudi authorities. Bombings against oil infrastructure or widespread sectarian unrest could threaten to disrupt Chinese supply.

In addition to physical threats to supply, political disputes could disrupt the delicate balance that makes Iraq an attractive commercial opportunity for international oil companies (IOCs). As ISIS has weakened Baghdad’s governance capacity, anger over violations of a shared oil export agreement between the central government and the Kurdistan Regional Government (KRG) has risen. This tension threatens to unravel the fragile oil-sales agreement, undermine reform efforts by KRG Prime Minister Haidar Abadi, deter future investment by IOCs, and potentially disrupt future Iraqi supply.

Compounding the energy security vulnerability caused by political and security instability is a crucial but largely overlooked side effect of the ongoing battle for market share: decreasing global spare capacity, the amount of production that can quickly come online in the event of a major market disruption to minimize price volatility.

Crude oil markets are most stable when spare capacity is at least 5 percent of total oil market demand, which amounts to roughly 4.7 mbd in today’s market. Traditionally, Saudi Arabia maintained sufficient spare capacity to stabilize the market in the wake of supply disruptions. As Riyadh has increased production to protect market share, however, its spare capacity has fallen significantly. Keen observers placed Saudi spare capacity it roughly 1 mbd in May before it ramped up production by roughly 300,000 barrels per day this summer. While it is difficult to pinpoint current Saudi spare capacity, it is clearly well below 5 percent of today’s market demand, and is expected to remain so at projected production levels. As a result, the safety net to ease the pain of a potential major supply disruption has vanished.

Troubling Implications

Low spare capacity has troubling implications for an import-dependent and energy-intensive country like China, whose economy has shown signs of fragility in recent months. China currently benefits from low oil prices and a market awash in excess crude; weathering a supply disruption is more manageable at $50 a barrel than $100. But given the infamous volatility of oil markets, China cannot depend on sustained low prices for its energy security.

So what can Beijing do to address its Middle East energy insecurity? In the short-term, the reality is: not much. Transitioning from a free-rider on the “public good” of U.S. security to regional guarantor would require force projection to rival that of the United States, and it is unlikely that Beijing is willing to invest the resources necessary for such a massive foreign undertaking. Additionally, China is on the wrong side of the Gulf’s security politics. Its de facto alignment with Iran, evidenced by their burgeoning naval cooperation, its United Nations Security Council vetoes with Russia of any action against the Syrian regime, and an alleged illicit nuclear pipeline from its private citizens to Iran make China an uncertain entity to the Gulf Arab monarchies. While the Gulf states may be willing to reap the benefits of Chinese trade and petrodollars, they are unlikely to warm to an external security presence so close to Iran. Beijing has taken some steps to secure its regional interests on a smaller scale through anti-piracy and evacuation missions, and could aim to boost bilateral ties with key exporters to further bolster the security of its interests. But for now at least, China’s energy security will largely be reliant on U.S.-led efforts to stabilize the regional security situation.

From a domestic perspective, Beijing could create its own supply security by building out its strategic petroleum reserve (SPR), a process that is already well underway. The size and composition of China’s SPR is shrouded in secrecy, but the Chinese National Bureau of Statistics announced in November 2014 that China had amassed 91 million barrels of crude, equating to roughly 30 days of import protection, in the first phase of its strategic stockpiling efforts; it aims to add another 168 million barrels to its strategic reserves in the next phase. However, this effort is complicated by China’s need to build new storage infrastructure, as it reportedly filled nearly all of its current storage capacity during a buying spree late last year. Furthermore, analysts estimate that China must amass roughly 600 million barrels in strategic reserves to match the import protection required of International Energy Agency (IEA) member states, a goal that Beijing is years away from realizing.

Given these realities and the outsized role that China plays in the global commodities trade, the country’s reliance on Middle Eastern oil constitutes a very real threat to the stability of energy markets and the global economic order. A major energy supply disruption today would place even greater stress on the Chinese economy, which is currently reeling in the wake of this summer’s stock market crash, and could potentially cause grave harm to financial markets across the globe. For this reason, it is critically important for the international community to engage with China to address its energy security vulnerabilities and head off a potential international crisis.