China's growing purchases of Russian oil carry hidden risks

Discounted prices invite additional political costs

Sep. 5, 2022

Shandong Province in eastern China boasts the country's cheapest gas stations. (July, Linyi, Shandong Province)

Tensions between the U.S. and China ratcheted up in early August when Nancy Pelosi, the speaker of the U.S. House of Representatives, visited Taiwan. China responded with live-fire military drills around the island, but the region has more to worry about than armed conflict.

Before Pelosi's visit, and with global oil prices continuing to rise, a strange phenomenon was spreading in eastern China's Shandong Province in early July.

It was visible in the city of Linyi, where one gas station had signs screaming at drivers: "Gas is 6.78 yuan [$1] a liter, the lowest in China. Car washes are also free." The messages drew a constant line of cars waiting to fill up at the Shandong Petrochemical gas station.

The price was 25% lower than the official government price [9.05 yuan at the time]. "I'll empty my tank as much as I can since it's so cheap around here," said Meng Jun, an office worker on a business trip from the Guangxi Zhuang Autonomous Region, 1,800 kilometers away.

Many other businesses were selling gas for about 7 yuan a liter. A person familiar with the situation explains: "They're buying a lot of cheap Russian oil while the U.S. isn't looking."

Shandong has clusters of private oil refining companies. (From the social media of Shandong Dongming Petrochemical Group)

Although China is the world's fourth largest country by land mass, it has chronic resource shortages. It imports about 70% of its crude oil. If that flow were to stop, many Chinese would find themselves cut off from modern life.

As the Chinese economy continues to grow, though slowly now that it is on the grip of a zero-COVID policy, the administration of President Xi Jinping is rushing to secure stable supplies of resources. One reason for this is the potential for a Taiwan contingency.

However, the rush is creating a great deal of friction.

Managers at independent oil refiners clustered in Shandong keep a close eye on the daily crude oil market. "Buy ESPO now." ESPO stands for the East Siberia-Pacific Ocean oil pipeline. It starts in Eastern Siberia and allows oil to flow to China from Kozmino and other ports in Russia's far east.

Japan, the U.S. and Europe responded to Russia's invasion of Ukraine with an embargo on Russian crude oil. China has not.

Data shows that 46 large vessels in July crossed from Russia's far east to ports in Qingdao and Dongjiakou, in China's Shandong Province. That is 1.9 times more than made the journey in January. Companies in Shandong are quietly at work, and the amount of crude oil purchased in July was almost double that of May.

The issue is payments. Major Russian banks have been cut off from the Society for Worldwide Interbank Telecommunications (SWIFT). So how are Chinese companies getting their payments to Russia?

On June 29, a cargo plane full of Xiaomi smartphones and other Chinese information technology gear took off from Xi'an, in the inland province of Shaanxi. Its destination was St. Petersburg, Russia, 6,000 miles away.

According to a person with knowledge of the flight, the cargo was used as barter. China buys Russian oil in yuan, which Russia then uses to buy China-made IT equipment. The transactions are thought to be backed by China's state-owned, oil-related Bank of Kunlun, which frequently interacts with Iran, another target of U.S. sanctions.

No matter if Western countries join ranks to shut out their adversaries, China is unaffected.

An order comes down from an executive at a major state-owned enterprise: "Increase Russian procurement by one-third."

China depends on imports for 46% of its natural gas. Russian gas makes up 10% of this. Japanese companies have also looked to grow their business with Russia through the Sakhalin-2 gas project.

An LNG tanker loads liquefied natural gas at Sakhalin-2 in October 2021. AP/Kyodo

Chinese companies plan to gradually expand their share of procurement while looking toward 2030, when long-term contracts with Japanese companies expire. Natural gas, with its low environmental impact, is key to the Xi administration, which has pledged to "protect the blue skies." In 2021 China surpassed Japan in liquefied natural gas imports by volume, and its purchasing power will increase from here on out.

For Japan, a tough situation is bound to grow more difficult. Its size makes it difficult to compete with China.

The population of India will overtake that of China in 2023. That's next year, folks. However, China will still be ahead in per capita wealth, with Chinese gunning for even higher living standards. If the Chinese public cannot continue heavily consuming, the government will come under pressure.

Japan will continue to face off against such a neighbor.

Russia and China bury gas pipelines along with their risks

After it invaded Ukraine, Russia came under sanction from the U.S., Europe, Japan and a host of other countries. From this weakened base, Russia is now being underpinned by China.

As energy prices soar and their economy turns down due to the COVID-19 pandemic, Chinese are growing increasingly discontent. That has the country's leaders looking to increase procurement from Russia.

But a risk lurks within this calculation.

"Gas piping present. Excavation strictly prohibited." A yellow sign bearing this warning stood in an endless cornfield in the city of Panjin, Liaoning Province, in northeastern China. "There's a huge pipeline buried underground that carries natural gas coming from Russia," said 73-year-old Wang Hong-Sheng, who manages the farm.

A pipeline carrying natural gas from Russia to China is buried beneath this field. (June, Liaoning Province)

It is the first natural gas pipeline to connect China and Russia. It traverses 3,300 km in China alone, which is a little longer than the drive from Singapore to Hanoi.

A section from Russia's East Siberia to China's Jilin Province came online in December 2019. A year later it was connected to Hebei Province through Liaoning Province. It is expected to be completed in 2025 when it reaches Shanghai.

Even now, with Russia under sanction, construction shows no signs of stopping.

The Chinese government used some coercion to execute the plan, seizing sites and forcibly evicting residents in various locations. For Wang, about 10% of his roughly 2,000 square meters of farmland hosts underground pipes. During construction, which started in 2020 and lasted about a year, he could not farm. The government gave him a bit over 3,000 yuan (about $445) in compensation, he said.

When construction ended, he could once again use the field. However, its yield dropped by 10%, likely because of soil deterioration, he said. "It's an important national project," he said with a weak smile. "The common people just follow orders."

China's economy is slumping partly because of the government's strict zero-COVID policy, which mandates lockdowns when cases pick up. Russia's invasion of Ukraine as well as interest rate hikes in Europe and the U.S. also factor in. Real gross domestic product for the April-June period grew 0.4% year-on-year.

Facilities related to a pipeline that carries natural gas from Russia to China. (June, Shenyang, Liaoning Province)

Because China has always had to import resources, today's soaring prices, especially those for energy, are also placing downward pressure on the economy. This makes Russia an attractive partner. Because of the sanctions, Russia is having to lure customers by cutting its resource prices.

"We want to reduce losses by using low-priced Russian products," said a senior executive of a privately owned company operating an oil refinery in Shandong.

A number of private companies have refineries in the province, including Shandong Sea Right Petrochemical Group, which has been sanctioned by the U.S. government for its dealings with Iran. However, the economic downturn has put most of the companies in the red, convincing them to import large quantities of Russian crude.

In late June, and for the second time this year, China's Ministry of Commerce announced that it will increase the quota for crude oil imports by non-state-owned enterprises by 1.5 times year-on-year. The goal is to expand procurement of Russian crude oil as local companies are less at risk of being sanctioned than the three major state-owned companies, such as Sinopec Group.

Senior positions in the Chinese Communist Party will be distributed this fall at the party congress, held once every five years. In the lead-up to the big political event, Xi's administration is prioritizing stability at home and deepening ties with Russia.

Judging by the U.S.'s repeated warnings to China that it not support Russia militarily or economically, China could become just as isolated as Russia.