Military tension between the U.S. and China in the South China Sea (SCS) often obscures what is an issue of energy and economic security. The SCS holds an estimated 190 trillion cubic feet of natural gas and 11 billion barrels of oil, if not more. These discovered and undiscovered reserves are gradually becoming more important as undisputed sovereign oil and gas fields mature and power demands increase. While the fight above the surface will be about missiles and air strips, the fight below the surface will be all about rights to exploration and extraction.
Shifting energy security dynamics for the U.S. and China
The context for this struggle has evolved dramatically over the past decade. Prior to 2008, the South China Sea loomed as one of many fronts in which Washington and Beijing sought to outrace each other to secure oil and gas reserves in the face of surging demand and fraught geopolitical tensions in Iraq, Venezuela and Nigeria. China’s oil imports doubled from 2004 to 2008, raising alarm bells in Beijing, which responded by encouraging a “go abroad” strategy for its national oil companies (NOCs). This strategy took China’s previously domestic-focused NOCs to far flung markets from the Canadian oil sands to Venezuela to Angola. Naturally, further expansion into South China Sea exploration made sense in this context, including a closer look at disputed areas.
China also places significant value on improving the technological and operational sophistication of its NOCs in a wide range of areas, including offshore development. The 1981 partnership to develop Pearl River Basin assets with U.S. super-major Phillips Petroleum was an early successful venture, which later expanded to include further developments in Bohai Bay, producing a cumulative 366 million barrels by 2010. The 2011 acquisition of Canadian oil producer Nexen Energy was seen as an opportunity to partner the China National Offshore Oil Corporation (CNOOC) with one of the leading deepwater exploration players with experience in key basins such as the Gulf of Mexico, the North Sea and West Africa. Around this same time, China began to develop self-sufficiency in the construction of ultra-deepwater rigs capable of drilling to 15,000 meters, both reducing its dependence on foreign partners and setting the stage for competition with other Asian shipyards. While still at a very early stage, this self-sufficiency is critical in moving Chinese rigs into disputed South China Sea waters that other suppliers may want to avoid for geopolitical reasons.
On the U.S. side, during the first decade of the 2000s, both super-majors and large independents were emphasizing deepwater exploration and increasingly saw competition from China emerging from Angola to the Caspian. Yet beginning in 2011, the focus of U.S. oil giants began to shift away from new frontier deepwater projects to unconventional gas (first) and oil (subsequently) in the shale basins of the lower 48 states. As a result, international deepwater activity, partly led by U.S. oil majors and independents, has been severely curtailed: less than 2 billion barrel of oil equivalent (boe) deepwater resources were sanctioned in 2016, down from more than 6 billion boe in 2013. Additionally, U.S. imports of crude oil decreased from 3.3 billion barrels in 2011 to 2.9 billion barrels in 2017, while exports surged from 17 million barrels to 422 million barrels during the same timeframe. In this context, the South China Sea is less strategic from an energy sector perspective, both for overall U.S. energy security, and for the investment and development opportunities of U.S. energy companies shifting to abundant domestic shale resources. Nonetheless, the South China Sea remains critical in terms of geopolitics and foreign policy as discussed further below.
ASEAN energy demand booming
The Association of Southeastern Asian Nations (ASEAN) states have both geopolitical and energy interests at play in the South China Sea. The geopolitical dynamic is focused on the increasingly difficult task of balancing relationships with China and the U.S. Trump’s “America First” policies create uncertainty about long-term U.S. objectives focused on building regional security alliances and open trade, with tensions around the latter undermining the former. The Indo-Pacific Initiative is the Trump Administration’s strategy for consolidating ASEAN in partnership with Australia, India and the U.S., as a counterpart to China’s Belt and Road Initiative (BRI). Yet the commercial muscle behind the plan is dwarfed by the BRI, particularly in the area of energy. The Trump administration sees U.S. LNG as a critical foreign policy tool to strengthen ties in Asia and draw regional states away from growing dependence on the BRI and other Chinese tools of economic diplomacy or, as some would argue, dependence. The Asia EDGE (Enhancing Development and Growth through Energy) program is meant to underwrite U.S.-ASEAN energy links but has only limited impact and a modest funding of USD 50 million planned for 2018.
ASEAN states are facing significant energy demand growth, in many ways similar to what China experienced in the last 15 years. The reversal of major ASEAN markets Indonesia and Malaysia from net exporters of crude and natural gas to net importers signifies the growing energy security concerns in the region and the need for new supply from abroad as well as closer to home. U.S. crude oil and LNG are attractive, but like China, the ASEAN states will seek diversity of supply, including through their own mostly offshore domestic gas resources. The combination of strong economic growth and declining domestic energy supply is not lost on OPEC, as Saudi Arabia is pursuing refinery projects in Malaysia alongside a major Kuwaiti investment in a refinery in Vietnam. Russia too is looking at refinery partnerships and LNG deals across the ASEAN region.
Gas in particular is in strong demand as a strategy to reduce air quality challenges emerging from fast-growing coal-fired power generation. This brings offshore gas into play in countries across the South China Sea, including Thailand, Vietnam, Brunei, Malaysia, Indonesia, and the Philippines. China’s nine-dash line (9DL) strategy creates uncertainty about the political stability of these projects and raises some doubts among the international investors and oil/gas producers that would be essential partners to many of these projects.
Notwithstanding geopolitical risks, South China Sea oil and gas may see a new wave of interest. The 2019 International Energy Association (IEA) World Energy Investment Outlook shows that both actual 2018 and expected 2019 global deepwater spending is growing after four years of decline. Several factors are ramping up spending in the region and demand has been strong in Southeast Asia, with oil demand growing by 52 percent and gas consumption almost doubled between 2000-2017. In addition, deepwater drillship rates are structurally and cyclically lower, plunging from around $600,000 in 2013-14 to about $150,000 in 2018. Interest in deepwater from local national oil companies like PTT (Thailand), PT Pertamina (Indonesia), PetroVietnam (Vietnam), and Petronas (Malaysia) are growing. Petronas, for instance, revised fiscal terms for Malaysia deepwater production sharing contracts in November 2018 to attract investment.
China asserts its interests in the South China Sea
The geopolitical struggle over South China Sea rights will take place primarily in the overlap of China’s 9DL and the exclusive economic zones (EEZ) of the Philippines, Malaysia, Brunei, Thailand and Vietnam. So far, China’s approach to the overlapping claims has been a mix of bargaining and bullying. In 2017, China reportedly threatened the Vietnamese government with military action if it did not stop activity in block 136/03, which straddles Vietnam’s EEZ and China’s 9DL. Vietnam capitulated and suspended drilling, which had been contracted to Repsol, a Spanish company. Then again in March 2018, Repsol was ordered to halt drilling activity in block 07/03. According to some maps, 07/03, known as “red emperor,” lies just outside the 9DL; however, China keeps the exact location of the line ambiguous.
Carrots have been offered as well. Last year, China convinced the Philippines to sign a memorandum of understanding (MOU) on joint oil and gas exploration in an area within the Philippines’ EEZ. The MOU was the result of Philippine President Rodrigo Duterte’s’ decision to deal with China more “pragmatically.” In other words, he decided to exchange a hard line on China’s aggressive activities in the South China for agreements to fund domestic infrastructure.
China’s goal is to replicate what was done with the Philippines with all SCS claimants. This bilateral approach—securing commitments for joint exploration in exchange for economic largesse—pointedly excludes the United States and advantages China as the most powerful partner in the equation. The opportunity for all the non-China claimants to push back collectivity is undermined by Duterte’s pivot as well as China’s influence on ASEAN.
Code of Conduct will shape future energy development
Currently, ASEAN and China are working on a Code of Conduct (COC) for the South China Sea, an upgrade from the non-binding Declaration of Conduct agreed upon in 2002. A draft agreement of the COC was agreed upon last summer by ASEAN and Chinese foreign ministers, but negotiations continue to drag on and the text has not yet been made public. Reportedly, some countries are chafing over China’s desire to include a line that calls for limiting joint development deals to China and Southeast Asian states.
The U.S. supports the COC process but has its own interests as stake. First, even though the energy security dimension is less critical for Washington than a decade ago, the U.S. does not want its companies to be excluded from key tenders in disputed blocks or bullied into ceasing operations.
Currently, the U.S.’s Murphy Oil is in the exploration stage of a Vietnam-leased field that falls slightly within the 9DL. Second, the U.S. has little interest in having China’s 9DL and claim over the entire area recognized—even tacitly. U.S. companies have a significant stake in freedom of navigation through the South China Sea, which is an important trade route. If, for example, an accident that happens while the U.S. is conducting a freedom of navigation operation around a reclaimed Chinese feature escalates, foreign companies would have to immediately bear the cost of diverted shipping. If that accident escalates to a full-blown war, it could impact the U.S.’s GDP by up to 5 percent and China’s by up to 25 percent (RAND, 2017).
The U.S.-China tension that has been growing over trade, ideology, and global influence under President Donald Trump and President Xi Jinping makes the latter scenario much more likely. Other moves, like the Trump administration’s decision to withdraw from the Intermediate-Range Nuclear Forces Treaty with Russia and China’s naval modernization drive, up the stakes even further. But in the end, it could be energy demand needs of both ASEAN and China that force a resolution of the SCS dispute.
Robert Johnston returned in 2018 to leading the firm’s Global Energy and Natural Resources (GENR) group after serving as Eurasia Group’s chief executive officer for five years and steering the firm through a period of strong growth and global expansion.