Oil and gas:

CSIS's Alan Hegburg talks geopolitics of China, India's increasing demand for oil

What effect are the growing economies of China and India having on world oil markets? What effect will expanding Asian demand have on U.S. access to oil -- particularly in the Middle East? Could competing demands for steady supplies lead to international conflicts? Alan Hegburg, senior energy fellow at the Center for Strategic and International Studies and energy consultant for the Scowcroft Group, discusses the rising oil demand from Asia's developing giants and how it could affect U.S. supplies and international relations.


Brian Stempeck: Hello and welcome to OnPoint. I'm Brian Stempeck. With us today is Alan Hegberg, senior fellow at the Center for Strategic and International Studies, and today we're going to be talking about the rising demand for oil from China and India. Al thanks a lot for joining us.

Alan Hegberg: Brian, thanks very much for the invitation.

Brian Stempeck: A lot of the Congress are saying right now that with a lot of higher demand from China and India for oil, we're not really seeing a short-term spike in prices right now, this is something that is here to stay. Do you agree with that?

Alan Hegberg: There are two versions of that and I think the alternative version is that it's going to be a longer term, higher price environment we're going to be in for several years and that's partly because demand has not declined in response to higher prices and in part because the existing infrastructure in oil is inadequate to sustain these high levels of demand. Keep in mind that demand for oil has been growing rapidly over the past two years and much more rapidly than it has in the previous three years. For example, in 2004 demand was up at a rate that's three times the average of the previous three years. It gives you an idea of the impact of oil demand on the world market price and it's probably going to be there for a while.

Brian Stempeck: Why is the market not responding in the usual way? Typical economic theory says when the price goes up --

Alan Hegberg: That's right.

Brian Stempeck: People stop buying, but why are we not seeing the market kind of respond and demand decline?

Alan Hegberg: There's always been these arguments that that's what will happen that in fact demand will go down due to income and price elasticities and there is some of that going on in the market, in some marketplaces it's happening, but in China and to some extent here economic growth is still very high. As a result, oil demand remains high in spite of the higher prices. So there has to be some other reason, it's either in the financial markets or in the fact that the U.S. economy is much less oil dependent than it was in the past. So everything hinges on transportation and transportation demand has not gone down very much and that's partly because there are no alternatives to people that are driving their cars.

Brian Stempeck: Why is the Chinese demand rising so fast right now? The Chinese economy has been going pretty red hot for much longer a time than their energy demand has gone up. Why only recently? Why only in the past year that the demand has really gone up from China and India and these other countries in Asia?

Alan Hegberg: Well, I think there were two reasons in 2004, one is that the demand really did accelerate, but the second is that they had shortages in their power sector and as a result they had to use diesel to provide power and that increased oil demand. So if you look at the demand increase in China in 2004, which was about a million barrels a day, that means that probably 20 percent of that, give or take, and don't hold me to the numbers, probably had to do with, not the structural change in the market, but problems in the short term in meeting demand in any electricity sector and as long as that continues that demand will continue high.

Brian Stempeck: So where is the Chinese government looking now to get their oil? They obviously already import quite a bit from the Middle East, where else are they looking?

Alan Hegberg: Well Chinese companies are out looking for oil and not the Chinese government and the Chinese --

Brian Stempeck: Well they're state-owned companies, right?

Alan Hegberg: They're state owned, but it's not at all clear that the government is directing them to go to specific countries. They're going off on their own, in fact, you find in some countries, when they're bidding for acreage, the Chinese companies will bid against themselves. So they're not working in lockstep. It's not like the Japanese companies in the old days who worked in lockstep for the government. They're looking for those kinds of crudes that they need in the short term to supply their market, which tend to be the lighter, sweeter crudes. So we'll see them in Algeria, you'll see them in Angola, you'll see them in Nigeria and West Africa, but you'll also see them in Saudi Arabia and China and various other places where the crude qualities are not as good and as long as they have enough sweet crude coming in to blend they can actually use those kind of crudes together. At the same time, the Chinese have begun to restructure their refining sector to take a broader range of crude oils and that should mean that their array of investment opportunities will be wider rather than narrow as they look for crude oils that are cheaper than the sweet crudes which are most expensive.

Brian Stempeck: So are we seeing a conflict between where China is looking for oil and where, you know, American multinationals and European oil companies typically go? I mean are these contracts that American and European firms should have locked down?

Alan Hegberg: Well, the process tends to be very competitive in the oil market for these contracts and U.S. companies, I think, will complain that the Chinese are able to underbid them. In other words, they will go out and pay more for access to the acreage than U.S. companies are willing to do. In part because their hurdle rates tend to be lower, their cost of capital is lower and U.S. companies don't have those kinds of advantages. So, that kind of competition out there is real. Will it get worse? Well, it depends, I mean it really depends on what happens in the marketplace and the demand that is needed for oil in various places and whether or not it continues at high levels. But what has happened in the marketplace over the last couple of years is that those places where there is adequate oil are relatively few. If you go back and look in the '70s and '80s there was a wide array of opportunities to invest in the North Sea and various places and all of that production came on line and now it's tending to peak and that means the new investments are going to have to be either in the Arabian Gulf area, some in West Africa and some in Latin America. Other than that, most companies are not interested in chasing opportunities in places where they historically have been.

Brian Stempeck: Right, I mean, one of the places that China is looking is Sudan. They have some oil supplies they're trying to lock down over there. That's simply not a place, you used to work for a number of major oil companies, that's typically not a place you'd see a private firm going into, correct?

Alan Hegberg: Well, no, I mean Sudan tried to attract companies, commercial companies back, oh, going back 20 years and in fact a number of companies did invest in Sudan. Some companies did not invest in Sudan and partly because there was no pipeline to get the oil from where it was to the coast. That changed. So the first investors in Sudan tend to have been commercial companies, including U.S. companies that had an interest there. They relinquished their acreage or gave it up and the Chinese and other companies have come in. It's not all Chinese companies in the Sudan. There have been in the past Canadian companies, there've French companies, so nationality in that case has not been a determining factor.

Brian Stempeck: What do you see as some of the foreign policy ramifications for the United States? One of the countries that China is looking to get more oil from is Iran and they're really stretching their ties with the Middle East, which could be problematic if you're looking out 10, 15 years. How do you see this shaping up in the next couple decades?

Alan Hegberg: Well, I think on the one hand it's clear that the Chinese have used their interest and their role in the Security Council for political objectives when it comes to investment, and I think it probably would complicate our efforts to take Iran to the Security Council to get sanctions on Iran if China were to use its veto power and that's a complicating factor. It's not sure that that would happen that way, but the Chinese have obviously used it in Iran, they have used it in Kuwait. So they are willing to try to leverage their interest in a country for political reasons. At the same time, it doesn't work everywhere and China companies, Chinese companies have to play by the rules that are there and if governments are willing to sort of provide oil to the Chinese under favorable terms and then they think it's a security question, then I think they'll probably raise the prices on the Chinese companies. So in fact they could be in a position where their commercial interests are nowhere near as responsive to the market as they had been in the past. What does it mean for competition with other companies in the major areas? Well, we've seen China, not just in Iran, but certainly in Canada and there's talk of Canadians building a pipeline to the West Coast --

Brian Stempeck: Right.

Alan Hegberg: So they can export crude oil. There is Chinese, at least buying of oil. There's been a recent case of a major Chinese purchase of oil in Venezuela. So the Chinese are out there in the marketplace buying things that they actually need for their marketplace and they're looking to diversify their import base, which is what we did in the '60s and '70s and '80s. We diversified the number of suppliers we had coming into the U.S. market because the issue for China, I think, is like it was for the United States. It's not so much dependency on foreign oil, but the vulnerability and the vulnerability goes up when you only have a couple of suppliers. So you want as many suppliers to your marketplace as possible and the U.S. has that because it's the most attractive market for people to sell oil.

Brian Stempeck: Is this raising red flags for people at the Pentagon, for policymakers in the U.S.? I mean these are traditionally U.S. suppliers, Venezuela, Canada, now China is also looking at some of the oil sands up in Canada. I mean, how much of a threat is this perceived by the Pentagon and by the Defense Department?

Alan Hegberg: I think there is three groups of people who look at the Chinese issues, and I think you're right, the Defense Department and the security community in United States looks at this as a great threat. I think it's a legitimate issue for them to pursue, no question about that because there are issues out there, particularly if the market is going to be tight and could affect our war fighting capability or our foreign policy. So there is a legitimate security interest. I think the real question is whether you go from the current state and then create this sort of scenario which is really quite extreme. There's been some of that at the margin. That's sort of one group of people. There are the economists who will say, "Look, it's really a good idea for the Chinese to be investing around the world because that's actually going to lead to more supplies. If they invest in Canada, fine. There's tons of oil in Canada. It'll drive down the cost of Canadian oil to us. It's better for us on the price side because there's going to be more oil available to everybody." That's a legitimate objective also. And then there are the commercial interests, which tend to be the private sector interest, who see the Chinese as competitors and that they are unable to compete with them and that reduces their ability to replace their reserves. So I think they have a concern about the commercial side of the equation. That is not a security question, as much as it is a question of being able to replace reserves and actually stay as viable companies.

Brian Stempeck: Staying on the security question. One thing that China is also doing is they're looking towards building a deepwater Navy, really strengthening the Navy to kind of protect some of these oil tankers that are going through the South China Sea around there. Is that a concern as well? I mean I know, I was at an event earlier this week where Newt Gingrich, the former House Speaker, was saying, basically told some visiting Chinese diplomats and some scholars that this is a serious issue. If you build up your Navy we're going to start having unable arms race. Is that more of the extreme camp or do you see that as a legitimate threat?

Alan Hegberg: I assume, I assume there are people in China who are actually talking about this. There are also people in China who know that sustaining this level of import growth is not good for the Chinese economy and that you can take economic steps in China to rationalize the energy economy and have world market prices and actually sustain an economy that is still dependent on imported oil, but doesn't grow at 7 or 8 or 9 percent growth a year. That's probably better for them because it is actually a cheaper approach than trying to build a Navy. Building a Navy is not an easy undertaking and if they want a major Navy that's a very expensive proposition. I would doubt, in the short term, and I'm not a naval analyst, by any stretch of the imagination, that going down that road was probably not their first option, but I think it's worth the Defense Department and others to pay attention to this and really look at the economics of what the best option for the Chinese is. It may be that they have some small additions to their Navy while at the same time changing the way in which they import, bringing oil in through Burma through a pipeline, bringing oil in from Kazakhstan, bringing oil and gas again from Russia into China and then they're not dependent on the sea lanes. So they would diversify their system also to make sure that they're not dependent on one mechanism for getting oil to the marketplace.

Brian Stempeck: On the demand-side, China, they've basically instituted a, kind of a fuel economy program to boost the economy of the cars and trucks sold there. What else are they doing to try to reduce demand?

Alan Hegberg: Well, they've got price issues from the producing side that they have to resolve. There's some competitive issues in the power sector, which means that some power projects can't recover their costs. So they have to find a way to make sure that when investors, particularly the Chinese investors, but also foreign investors, are in a marketplace that is open and in fact a market place and not directed. That's always been the case with the Chinese economy because part of it is directed and part of it is free there's always a tension between how fast you modernize and how fast you privatize things. There is indications that they're getting ready to privatize the state companies.

Brian Stempeck: One thing I know that they're looking at that you have commented on in the past is kind of looking at a regional Asian oil block, some way to kind of consolidate supplies there. I know you said that's a bad idea. Can you explain why? Why is that a bad idea?

Alan Hegberg: Why would you look narrowly for your oil supplies when you could look broadly, I mean broadly, the marketplace for oil is well developed. It's very sophisticated. It's very efficient. It works very well. It's price sensitive. Why would you decide to only look for very few places of oil because at some point that oil is going to peak and then you're back in the same problem you were in before? So you either put your faith in the whole market or not faith in part of the market. It seems to me the Chinese, if they go down that road, and the Indians have talked about that too, I think there is sort of a political dynamic behind that. I don't think there's a real oil policy dynamic behind it.

Brian Stempeck: We've talked a lot about China, what's kind of the stage with India? Obviously their growth is going much higher as well. How are they reacting? Where are they looking for supplies and what kind of demand side things are they doing as well?

Alan Hegberg: Well their natural suppliers come from the Persian Gulf and the Arabian Gulf in oil and gas and I think that will be their principal place of supply. They may get some from Central Asia, from pipelines, but most of the import facilities are along the coast and I think you'll see, in natural gas in particular, an increase in natural gas in the southern part of India and you'll see an increase in oil. But already India has gasoline prices which are quite high. So their demand growth is probably, it's going to go up. I think there's no question about that, but I don't think it will go up at the rates or in the volumes that you see in China even though India is a huge country. Unless of course India has a massive transformation and the poor in India, which are very substantial and are essentially without energy, all of the sudden start to grow and increase demand. I think that's where it would happen in India.

Brian Stempeck: What do you say to policymakers in the U.S., to members of Congress, they're debating an energy bill right now, as they have been for the past few years. Is there anything in that bill or anything in the White House policies that can really do anything about some of these global supply questions that we're talking about?

Alan Hegberg: Well, if you're talking about in the short term, is there anything to bring more oil to the market in the short term? The only available supply is the strategic petroleum reserve and if the administration were willing to do that they could take sweet oil out of there and put that into the refining sector in the United States to help with the price question. They have decided not to do that. So there are no other immediate supplies. The second problem is the refining sector worldwide is very tight and as everyone knows, now it certainly is, and the paper market is showing this, there is concerned about the capacity in the refining market to be inadequate in the third and fourth quarters to meet demand and that will drive prices higher. I don't know whether that will happen or not, but if you forecast demand at some level it's likely to be continually a tight marketplace. In the longer term, the debate has gone on over policy in this country for 30 years, it started in the Carter administration, is whether you produce your way out of it domestically or try to save your way out of it through more efficiency and conservation and alternative fuels and things like that. The administration seems to favor a produce first policy, which has some advantages to it. The problem is that the United States has been heavily drilled. I think the companies, if you look at the major international companies, they don't generally invest in the United States with the exception of the Gulf of Mexico and the deep water and some in Alaska, but the large accumulations of oil do not seem to be in the United States. So you can actually give access to public lands and things like that, but you're probably not going to get a huge amount of oil out of that. You may get more gas than oil. So producing your way out of it in the short term is probably not a solution. Now having said that, what's going to happen in the short term is oil production in United States will go up as fields in the Gulf of Mexico start coming on stream and the deep water in the gulf and there's some prospects in the gulf that are very attractive and may actually be large accumulations of oil. If that's the case, then you can see an increase of a million barrels a day in the United States and of course ANWR. The issue in ANWR is, well a couple of issues with ANWR, but if it comes on in 2010 or something, at 800 or a thousand barrels a day or a million barrels a day, the question is where will it be consumed? Because a debate over whether or not it will be reserved for the U.S. market or be exported is ongoing. It hasn't been decided.

Brian Stempeck: Right.

Alan Hegberg: And if you put it into the Asian market that would mean that you'll have to find alternative fuel, alternative supplies for the U.S. West Coast. We'll see how that plays out, but that's actually the nature of the market. I mean, it's a functional market and if you export one place, you import another place.

Brian Stempeck: Sure. One last question for you Al, before we stop, as we're looking out over the next 10 years and China and India's demand is going way up, they're treading on some, you know, usually U.S. territory, like Venezuela and Canada, do you think some sort of foreign policy conflict is pretty much inevitable with those countries or can it be avoided?

Alan Hegberg: Oh, I think it can be avoided. Nothing is inevitable in politics as we know. So I think this is a case where it will take some sensible energy policy decisions and some sensible foreign policy decisions. I don't think it's in the advantage of anybody to have a conflict with India or China over oil supplies and it certainly isn't foreordained that we will have that and I certainly hope we don't.

Brian Stempeck: All right. We'll stop there. We're out of time.

Alan Hegberg: OK.

Brian Stempeck: I'd like to thank our guest today. That was Al Hegberg, senior fellow with the Center for Strategic and International Studies. I'm Brian Stempeck. This is OnPoint. Thanks for watching.

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