China’s growing LNG demand will shape markets, strategies

China began importing LNG in 2006 and is likely to expand its LNG imports greatly in coming years, particularly if Russia cannot make good on longstanding promises to build gas pipelines to China. To date, the two sides have been unable to agree on a price, with China wanting prices of $100/1,000 cu m and Russia seeking prices nearer the $250/1,000 cu m it realizes for gas sales to Western Europe.

China’s investment-led growth model leads to massive demand for inexpensive baseload electricity. Here coal will almost always prevail over gas, unless the government imposes draconian coal taxes, carbon-emission restrictions, or other such measures to lessen the raw fuel price disparity. Gas will gain from demands for generation flexibility, because unlike coal-fired plants, gas-fired combined cycle turbine plants can rapidly adjust their output.

Gas-fired generation also stands to benefit from growing electricity demand in southeast Chinese cities that are prosperous, far from coal supplies, lie near the coast, and are battling severe pollution.

Southern China

Sinopec and PetroChina are delaying LNG projects in northern China until more LNG supplies become available and the price situation improves. China is rich in coal, making LNG uncompetitive for baseload power generation at prices greater than $3.50/MMbtu. International LNG prices in August 2007 stood nearer $9-11/MMbtu. Japanese and Korean consumers can afford LNG at these prices, but relatively few Chinese consumers can. These customers are primarily in the more prosperous Shanghai, Fujian, and Pearl River Delta areas.

China’s relatively prosperous and economically dynamic Southeast will therefore be the primary demand center. Even regional Chinese LNG demand growth can have global market effects. By 2015, LNG demand in southeast China and Shanghai could exceed that of South Korea, which is currently the world’s No. 2 LNG consumer. Fig. 1 shows income levels in China’s southeast, where LNG terminals are being built, vs. the rest of the country.

High world LNG prices amid growing competition for supplies and increased domestic gas supplies are currently dampening Chinese LNG demand growth. Average international LNG prices exceed Chinese coal prices by a factor of four and could remain high for several years to come because new projects can take 5 or more years to come online.

A recent spate of domestic gas discoveries equal to more than 5 years of imports at China’s projected 2010 demand level will reduce China’s prospective LNG demand.3 China may also see domestic supply gains from its coalbed-methane reserves. Chinese residential gas prices are also controlled, making LNG largely uncompetitive at current price levels.

Although China’s internal gas market policies and the broad inability of consumers to pay current international LNG prices are curtailing demand, there may be changes afoot. In April 2007, Mitsui UK and CNOOC signed a framework accord on LNG spot trading. Then, on May 10, 2007, CNOOC’s Dapeng terminal accepted China’s first spot LNG cargo, which came from Oman and was purchased ex-ship from Mitsubishi.

The deal’s significance lies in the fact that for the first time, a Chinese local gas company was willing to pay full international price for gas imports. China’s Fujian and North West Shelf LNG import contracts featured low prices and were signed during an LNG buyers’ market.

Part of those deals’ low prices may also stem from energy companies working to establish a foothold in the potentially huge Chinese market. Yet the spot deal combined with the fact that China’s Ministry of Commerce recently eliminated gas import restrictions may signal that the Chinese government and Chinese companies are slowly moving toward greater integration with the international LNG market.

Greater participation by Chinese firms in the LNG spot market could also increase liquidity in East Asia, because South Korea’s KOGAS uses spot trading to help account for seasonal demand shifts and is already a leading global LNG spot market player.

Utilities in Southeast China also appear to be interested in LNG as a way to meet residential and industrial gas supply needs. Guangdong and the surrounding Pearl River Delta are economic powerhouses with some of China’s fastest growing electricity demand. Gas-fired power is competitive in these areas because serious rail bottlenecks raise coal delivery costs and cause supply interruptions for coal-fired power plants. In addition, oil-fired power plants in Guangdong are being shut down as China struggles to restrain rapid oil demand growth.1 Finally, because it burns cleanly, gas is also favored over oil and coal for power generation in the badly polluted southeast.

China Gas, one of the country’s largest pipeline gas distributors, expected to take its first LNG shipment in September.4 The company experienced a 145% surge in gas sales between April 2006 and March 2007 and is looking to expand its distribution operations to eight more cities. These events may mark the emergence of residential demand, a new gas-demand driver independent of electrical generation.

Asian LNG competition

Increased Chinese LNG demand will sharpen competition for LNG supplies in East Asia, particularly because Indonesia is looking to curtail export volumes sharply in order to meet domestic gas needs. Growing Chinese LNG import demands will also have geopolitical consequences. Australia, Indonesia, Malaysia, and Iran are seen as prime LNG sources.

The close bilateral ties between LNG producers and consumers will also influence China’s foreign policy. This means that China will oppose actions that might harm Iran’s energy development. In the case of Australia, a staunch US ally will find itself in the diplomatically delicate position of balancing deep strategic ties to the US and a burgeoning economic relationship with the PRC.

Finally, LNG shipments will travel the same sea lanes that oil imports do, posing an additional sea lane security issue in Southeast Asia and the Indian Ocean by 2020.

As Fig. 2 shows, Southeast Asian LNG supplies are already very important to Japan and South Korea. Given that the region lacks the LNG production growth potential of the Middle East, China’s growth as an LNG importer combined with its stated preference for sourcing supplies close to home likely means increased competition for future Southeast Asian LNG supplies.

Chinese companies may also seek to expand their role in the LNG value chain. Such moves would be logical, given that Chinese companies seek to maximize rent capture and ensure supply security in the oil business by becoming active in every link of the value chain. Chinese firms are seeking upstream stakes in fields slated to feed LNG projects. China’s shipyards are building vessels to serve domestic LNG projects and are eying the global LNG carrier market.

Finally, growth in China’s LNG sector will create near and medium-term commercial opportunities for engineering and construction firms capable of building LNG terminals and providers of LNG ship technology and materials, among others.

Seeking upstream stakes

Chinese energy producers will seek equity stakes in LNG projects to book reserves and possibly gain a say in where supplies go. Chinese drilling and service companies will pursue business in countries where Chinese firms have upstream stakes in LNG projects. If CNOOC and other Chinese national energy producers gain large upstream stakes, their service-provider subsidiaries such as COSL could latch onto new business.

China’s push into global energy services markets will be a major energy services theme during the next 10-15 years for both oil and gas. Chinese firms have been able to hone their skills in a large domestic market (world’s fifth largest oil producer and 16th largest gas producer) that gives them a strong base for jumping into the global energy service sector.

Great Wall Drilling Co. now provides drilling services in 26 countries and is the leading drilling contractor in Kazakhstan, Venezuela, Sudan, Egypt, and Pakistan.5 China exported $500 million worth of drilling equipment in 2005 (growth of 26.1%/year from 2002-05) and now counts the US as its single largest export market.6

While Chinese firms such as BOMCO can supply rigs at discounts of as much as 25% relative to Western firms, over at least the next 5 years, the advanced services of Halliburton, Schlumberger, and other Western service providers will be irreplaceable for developing LNG feed fields, many of which lie offshore and in other complex environments where multinational service providers’ technology and equipment still dominate.

Chinese firms weaker

North American, European, Japanese, and Korean firms currently dominate LNG-related engineering and construction, as they conduct both design work, as well as actual construction of liquefaction plants, loading wharves, regas facilities, and storage tanks. Prominent firms in the field include CBI, KBR, Samsung, and Tokyo Gas.

Chinese firms currently have no presence in the global LNG construction sector. If they move to gain market share, their primary value proposition would likely be low cost and a higher appetite for political risk, rather than the innovation, sophisticated technologies, and long-standing reputation that provide Western firms’ primary value added. Fig. 3 maps current Chinese LNG terminal projects, as well as their lead contractors.

If Chinese engineering and construction firms choose to compete for LNG terminal construction contracts, they may push for “national firms preferred” policies. For example, current Chinese government policy emphasizes hauling Chinese LNG imports on Chinese-made ships. Similar policies favoring Chinese engineering and construction firms for building future LNG import facilities (and possibly liquefaction facilities if a Chinese national energy company is the main upstream shareholder) would foster these companies’ international competitiveness by enabling them to gain experience prior to entering intense international bidding.

In the 10-15 year time frame, Chinese shipyards will likely come to play a more significant role in LNG carrier production. China’s burgeoning maritime academies could also help turn out badly needed LNG carrier officers and crewmen who, if they gained sufficient English language proficiency, could work for Chinese and international LNG shippers.

With the current orderbook, the world LNG fleet will require an estimated 5,000 or more new officers, double the current number.7 This number could climb further because many current officers have been at sea for more than 25 years and are nearing retirement. LNG crewing and officer training are therefore areas where China could positively affect the global LNG market. According to Poten & Partners, China is building training facilities aboard one of its newbuild LNG carriers.8

Naval expansion

China’s growing LNG imports may fuel blue water naval expansion. In the case of LNG sea lanes of communication security, being able militarily to protect one’s supply lines may in fact turn out to be far more important than in the case of oil. LNG is physically more difficult to handle than oil and is not as easily tradable. LNG is still sold primarily on the basis of long term take-or-pay contracts, with only about 10-12% of global volumes traded as spot cargoes. And even these spot cargoes change hands once or twice before reaching the final end user, whereas oil cargoes commonly pass through a dozen or more buyers and sellers before finally reaching the end user.

As a result, ties between LNG producers and consumers tend to be very direct. LNG projects are typically served by dedicated tankers that carry LNG on one route (for example, Qatar-Japan), and cargoes are rarely resold at sea.

From a military perspective, this would make shipments much easier to interdict because-in contrast with oil cargoes-it would be relatively simple to determine where an LNG cargo was headed. This means that a consumer nation has a strong motivation for possessing the capacity militarily to defend its LNG supply lanes. LNG carriers being built to serve Chinese terminals are currently either Hong Kong or PRC flagged, making it even simpler to justify using naval power to defend them during a crisis.

Looking ahead

China’s primary source of influence on the East Asian and global LNG markets in the next 5 years will be as a consumer of and competitor for supplies, particularly from Indonesia (falling production), Malaysia, Australia, and possibly Sakhalin. Chinese sources express a preference for obtaining LNG from these areas, as they are “close to home” and shipments do not need to pass through the Malacca Strait.

If Iran begins producing and exporting LNG, China will almost certainly take large volumes, deepening its energy interests in Iran and possibly sharpening tension with the West over Iran’s nuclear program.

Insofar as specific segments of the LNG value chain are concerned, Chinese shipping firms will serve the Chinese market but will face stiff international competition from Japanese, Korean, North American, and European shippers. China’s main contributions to the global LNG shipping sector would likely come from providing ship officers and crewmen, as well as building some LNG carriers (in the 10-year time frame). Although Chinese shipbuilders are making great strides, more technically advanced South Korean yards will likely capture the majority of LNG carrier orders.

CNOOC and other Chinese producing firms will seek upstream project stakes, and their service subsidiaries will be active in countries from which China is obtaining LNG. As southern and eastern Chinese power producers increase the share of gas-fired generation, it is possible that they could seek upstream stakes in LNG projects that feed their plants.

Western and Japanese power producers and utilities such as Gaz de France and Tokyo Gas now seek upstream stakes in LNG projects to ensure supply security for their plants and industrial and residential consumers.

For the foreseeable future, Chinese construction and engineering firms will enter the LNG construction business based on political rather than economic advantages. In Iran, for instance, KBR and other Western firms are effectively shut out by US sanctions. If tensions continue, Iran may have no choice but to rely on Chinese firms to help it build LNG infrastructure. China’s growing LNG demand could exert profound strategic and commercial effects on the relatively undeveloped global LNG market. Existing LNG consumers and suppliers in East Asia will need to make adjustments to deal with China’s rise.

As the LNG market continues to globalize, Atlantic Basin consumers in Western Europe and North America will feel the market effects of China’s growing LNG use. This will be particularly true as the US becomes a top global LNG importer. China and the US have the highest growth potential of new LNG importers worldwide and may become major demand-side shapers of the new global LNG market.

References

1. McGregor, Richard, “750,000 a Year Killed by Chinese Pollution,” Financial Times, July 2, 2007.
2. Xinhua News Agency.
3. Brower, Derek, “Natural Gas: Putting the Cart Before the Horse,” Petroleum Economist, December 2006. http://www.petroleum-economist.com.
4. “China Gas to Receive First Shipment of LNG Imports in September-Company Official,” Interfax, July 24, 2007, http://www.interfax.com/4/295789/news.aspx.
5. “GWDC Continued to Expand Its Presence in Worldwide Drilling Services Markets in 2005,” China Oil & Gas, No. 1, 2006 (31).
6. “Rapid Growth in China’s Oil & Gas Drilling Equipment Exports,” China Oil & Gas, No. 3, 2006 (50).
7. “Crew Shortage Tops Training Agenda,” Lloyd’s List. May 18, 2006. Lexis Nexis. http://web.lexis-nexis.com.
8. “Crewing Challenges Increase With Growing LNG Fleet,” LNG in World Markets, Poten & Partners, www.poten.com, Feb. 15, 2007.

The author

Gabriel Collins ([email protected]) is a research fellow in the US Naval War College’s China Maritime Studies Institute, Newport, RI. His primary research areas are Chinese and Russian energy policy, maritime energy security, Chinese shipbuilding, and Chinese naval modernization. Collins is an honors graduate (2005) of Princeton University and is proficient in Mandarin Chinese and Russian.