The following interview with Erica S. Downs [1] was carried out in Washington D.C., USA, January 13, 2014 by Patrick Renz and Frauke Heidemann. The main focus of the interview was on U.S. shale energy, Chinese investments overseas, Chinese freeriding on U.S. protection of global commons and upcoming challenges for Chinese investments. All footnotes are remarks by Patrick Renz and Frauke Heidemann, aimed at giving some additional background knowledge and especially giving the links to the cited documents so that the reader can follow up on these issues easily.

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. U.S. Shale Energy

Do you see the U.S. shale gas and tight oil production as impacting Chinese energy security?

It probably affects China’s energy security in a couple of ways. [2] One is that what has happened in the U.S. has generated a lot of interest in China as to whether the U.S. shale energy revolution can be replicated there. China has a lot of shale gas and oil resources on paper, 50% more than the U.S. in terms of gas [3] and therefore the government as well as companies have shown a lot of interest about whether they can commercially produce these resources.

Especially on the gas side that would be great for China as there has been this push going on for many years to increase the role of natural gas in China’s energy mix. If China is indeed sitting on considerable shale gas resources then that could help significantly. In recent years, mainly because of air pollution there has been even greater urgency to achieve this goal. Air pollution is however not the main driver. For all countries it is true that if you can produce a resource economically at home why not do that instead of importing. There is a lot of interest in whether China can replicate the U.S. shale energy revolution. A lot of experts agree that what happened in the U.S. was sort of unique. Some of the ingredients that lead to the success in the U.S. are not present in China. While in the U.S. if you are a farm owner in Pennsylvania and you are sitting on a lot of shale resources, those are yours, in China land ownership does not come with the mineral rights. Large differences can also be seen regarding the industry structure. Here it has been all these small really flexible companies run by people who really wanted to make a lot of money quickly, whereas in China you have these two large state-owned behemoths who are not necessary as nimble as the small companies that did the shale revolution in the U.S. and are not solely motivated by greed. That is one thing.

Other important implications are regarding the geopolitics of the U.S. shale energy revolution. Here the conversation quickly turns to the Persian Gulf. In China when it has come up in conversations, everybody is really interested in what this means geopolitically. The focus is especially on the scenario, that in 20 years the U.S. is importing almost no oil from the Persian Gulf and China is not only importing 6 or 7 million barrels per day (bbl/d), but also competing with other major consumers in Asia. The conversation is in some way the same as here in Washington D.C. If the U.S. isn’t importing any oil from the Gulf, are they going to be as engaged in the Gulf and will that be good or bad for China? What will this mean for the security of China’s oil supply from this region? Will China still be able to count on the U.S. Fifth Fleet just to sit there and deter any threats? Those are really hard questions to answers and there are just too many unknowns. Even if you talk to other experts here in the U.S. you get different opinions and it is hard to say what is going to happen. Experts are on different sides of this issue. It is easy to raise the right questions but is not easy to answer them.

Another highly important issue is the Russia relationship. There is a sense in Petro-China that the shale energy revolution is bad for Russia, and might give China an upper hand in negotiating a gas pipeline. An interesting question to me is whether this view is shared in Russia or not. One Russian expert told me they are not sure how long the shale revolution in the U.S. is actually going to last and therefore ten years from now everything might go down hill. For me what the Russians think is a big part of the equation. At least in China there is a sense that the Russians need them now more than ever because they face competitors for customers in Europe. Even before the U.S. shale energy revolution it didn’t look as if Europe would be a major source of energy demand growth in the future. If you look at natural gas for Europeans today, you see that they are not necessarily stuck with just Russian pipeline gas. There are LNG supplies that previously were destined for the U.S. and are now going to customers in Europe. Perhaps even the U.S. will export LNG to Europe one day. Therefore, from my perspective this really means that Gazprom needs to focus on China to grow its market share.

The last point in this regard is about the investment side. The shale energy revolution has created a lot of new opportunities for Chinese energy companies – not just in North America – but also elsewhere in the world. You have many U.S. companies that are selling their stakes abroad to invest at home because it is always easier to operate at home than abroad. You see Conoco Philips selling its stake in the Kashagan Consortium that China National Petroleum Corp. (CNPC) bought, [4] and if you look back at some of the business publications converging these deals you will find companies trying to optimize their assets, trying to sell off non-core assets, all just to take that money and invest it in North America. Thus, there have been a lot more opportunities for companies to buy. To complete the picture, you also have U.S. and international companies not buying new stakes because they are interested in the U.S. If there weren’t a shale energy revolution in the U.S., would Chinese energy companies be facing more competition from other companies for Canadian oil sands or for Brazilian offshore? [5] The answer is probably yes but we don’t know for sure.

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. Chinese NOCs Investments Overseas

What do you see as the primary goal behind the investments of Chinese National Oil Companies (NOCs) in U.S. companies involved in fracking?

Usually the press argues that it is about technology and expertise. There is a sense that Chinese companies do not have this expertise and they want it, which is why they come in and invest in the U.S. so they can learn. Broadly speaking or thinking long-term this is probably true as these companies do want to learn how to exploit resources in China. However, if you look at the specific transactions it does raise the question whether they are actually getting that from any of the specific investments they made in the U.S. and you can make the case that the answer to this is no.

If you look at the China National Offshore Oil Corp. (CNOOC) investments in Chesapeake there was this interview in the Wall Street Journal where they interviewed Fu Chengyu and asked him how the deal came about. [6] One of the things that I took away from this was that they really tried to structure the transaction in a way to deflect any political opposition up front. This means that it was a minority stake; there was no secondment of personnel. In fact there are other Chesapeake projects where they have people from StatOil or Total who are allowed to work in the U.S. on the project. Between CNOOC and Chesapeake however, there was a sense that this was politically unacceptable in the U.S. Consequently, today there is no secondment of personnel, no technology transfer, which raises the issue of what they are getting out of it. Some people argue fracking is not rocket science, there might be things that just by being involved in the project with a minority stake they could learn more about. I don’t know enough about these projects or about this business to know whether there is something they could learn from them but people have raised the question. Others say they don’t get any technology and it seems just like a financial investment, whereby you could then question if it was a smart financial investment.

Some experts also argue that if they wanted to get this technology, CNOOC or CNPC could go and buy a service company. Maybe not a U.S. service company because of the political uproar this would cause but my sense is that that there are companies they could buy. CNOOC bought Awilco as a way to build up their expertise. [7] If you want you can buy a service company. There seems to be recognition within CNOOC or Sinopec that they might want to expand their presence in the U.S. and no longer do this through high profile takeovers but rather start by taking minority stakes for approval from the U.S. Once the U.S. becomes aware that the world does not fall apart and that the Chinese companies are good corporate citizens this could open the door to them doing more in the future. Then they could argue that they have been operating in the U.S. for so many years and have been selling their oil locally as crude oil exports are banned. Furthermore they could argue they haven’t destroyed the environment and shareholders got good value. That makes sense before entering any new market. Start small and grow from there.

When Chinese NOCs invest abroad, in many cases they happen to do so in unstable regions. Some argue this is because they came “late” compared to Western companies and thereby have to take what is left. How do they secure those risky investments?

Some of the Chinese oil analysts argue exactly that. The companies started investing overseas, they were going to Sudan and Iran not because they think they are fantastic places to invest, but because they were arriving late to the international M&A game. The best investments were already in the hands of companies like Exxon Mobile and BP that started investing long before them and they couldn’t compete with those companies. Therefore they went where there was less competition and often where there is less competition it is in parts of the world where other companies could not or would not go. Looking at a specific example, it wasn’t necessarily the Chinese line of thought that Sudan was a great place to do business, but there was this great asset that would still be in the hands of Chevron if it were not for the North-South civil war. This is what they thought they had to take. The unconventional revolution has changed that a bit and in recent years there have been opportunities in the U.S. and Canada, which pose a different set of risks. For Chinese companies, the hardest part is completing the deal, but once your deal is complete it is a pretty safe place to operate. If you look at CNPC, in Kashagan they don’t have to worry that much about physical safety but more about cost overruns.

The security issue itself has undergone a certain change in recent years. When Chinese companies started investing overseas, they didn’t have any experience with the downside of investing in risky places. Today, this has changed due to certain lessons in risk management. There has been the South Sudan issue and there was Libya where even though they didn’t have huge oil assets many companies were investing. Even in Iran despite not that much money being spent, the sanctions forced the Chinese to slow down their upstream activities. In Ethiopia and South Sudan they had workers kidnapped and killed. Consequently, there is a recognition that it can be dangerous to go into those high-risk countries. [8] However, I do not have a good sense in terms of what has been done. Some articles call for more understanding of the environments in which they go into but I have not actually talked to anyone in the companies about this. It would be interesting to know how people at CNOOC and CNPC do political risk analysis. People in the foreign affairs bureaucracy in China have said that the companies don’t do enough to learn about the potential risks in countries they are investing in. Some may reflect that the people in the foreign affairs bureaucracy may not know what is actually going on in the companies. Investments are being made and until the company gets into trouble and comes calling for help they oftentimes do not know about the investments.

This implies that if the companies did a better job learning about the communities in which they are investing, maybe they would be better prepared to deal with some of the challenges. Finally, there is the whole issue beyond oil investments and more about Chinese companies and Chinese workers increasing their presence overseas. How do you protect Chinese nationals and Chinese assets overseas? My sense is that in before the creation of South Sudan, in Sudan CNPC was largely relying on Khartoum to handle any problems. I don’t know what is going on there now but you don’t really have a Chinese Private Security Company (PSC) operating. If I were a Chinese company, politically the optics might be better if PSC such as Blackwater were hired. At least from here in Washington looking at Chinese activities in Africa with a somewhat critical eye, CNPC hiring Blackwater or some variant of it to make sure their operations are safe just as all other oil companies operating abroad do, seems more acceptable and less anxiety induced than if CNPC is relying on Khartoum or Chinese military personnel.

You wrote in your article “China Buys into Afghanistan” [9] about the U.S. troop withdrawal from Afghanistan and potential affects on Chinese companies. How do you think the withdrawal will impact the investments of Chinese mining companies in the region?

My sense is that is has a rather large impact. The Chinese mining company Metallurgical Corporation of China (MCC) was really quite appreciative of the U.S. presence in the region as is their partner Jiangxi Copper Corporation (JCCL). For this to be freeriding it has to be a good that the Chinese value. If they don’t value the service it is not freeriding according to my discussion with Andrew Kennedy. [10] I was able to find statements made in Wall Street Journal with JCCL saying they appreciate the U.S. guarding their workers. [11] My finding from the interviews was that there is an appreciation for the U.S. presence and that this is good for China. Even though no U.S. military is assigned to the Aynak copper deposit, the fact that they are patrolling in Logar province is contributing to security. As 2014 got closer there were questions as to what sort of military presence the U.S. will maintain in the country and about the speed of the drawdown.

The Chinese investors don’t know how things are going to look like after 2014 and that has a lot to do with the security environment. Is it going to be a stable and safe enough place that they want to put a lot of money into? There is the uncertainty about the political future. One thing I heard a lot when I was doing interviews in Beijing with experts on Afghanistan was that Hamid Karzai is not the President of Afghanistan, he is just the major of Kabul. They were saying he does not have a lot of influence, fueling the uncertainty about what will happen after the withdrawal. They don’t want to invest if they don’t know who the powerbrokers are going to be. Chinese companies want to make sure that their interests are aligned with whoever is in power. There is the security environment, the uncertainty about the political landscape and about who is going to be in power in Kabul as well as locally.

Another important issue is all the talking about the MCC losing a lot of money. [12] They had a lot of losses because of bad investments at home as well as abroad and my guess is they are in a lot of trouble in Beijing. Therefore, we haven’t seen them making any new investments overseas, since they have done so many things and most of them turned out fairly disastrous. If you are MCC and you are facing all those bad overseas investments, given the security and political uncertainty in Afghanistan you might want to hold back from putting more money in there. I think they have not put that much in there to date.

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. Chinese Freeriding

Many experts we talked to looked at the Middle East as a region where China is freeriding on the U.S. protection of global commons. On January 9 the Chinese Foreign Minister announced that China wants to play a larger role in the Middle East. [13] Do you believe that this is energy related?

My sense is that it is accurate to say that China is freeriding on the U.S. Navy to provide the free flow of oil from the Middle East. As mentioned, Andrew Kennedy is working on this issue and looks on the issue of freeriding with regard to the sea-lanes and strategic petroleum reserves. He does an excellent job of really thinking through these issues. He was looking at the anti-piracy patrols in the Gulf of Aden and in his definition, China is not freeriding but very cheaply riding. His argument is that the PLA Navy is participating and saying they do something for regional security but that it is unclear whether they really are in it for the global good or rather for more narrow, institutional interests such as learning from the way the U.S. Navy is operating. They are however not totally freeriding because of their engagement in this regard.

What I always wonder about is that in the U.S. we like to criticize the Chinese for freeriding on sea-lane security and on security the U.S. military is providing in Afghanistan as well as in Iraq where they made all these investments. But the broader question is, if we do not want China to freeride, what do we want them to do? Even if China decides they do not want to freeride what they might decide to do does not have to be something the U.S. wants. China is freeriding or cheap riding because it worked out well and in part because it is a global oil market wherein they probably know that short of a war time situation their own and U.S. interest are going to be aligned. In Washington we always say we want the Chinese to be more active but in order for them to really do this they will need a bigger global footprint and more bases globally. Sometimes I wonder whether people think through what they are wishing for as it might include things we are very afraid of.

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. Upcoming Challenges

What do you see as the biggest challenge for China in the upcoming years?

One issue related to overseas investment – and that has been deeply embedded in the Chinese growth model focused on exports and investment-led growth at home – is that they need a lot of commodities to support economic growth. The big question is about moving away from that growth model that is running out of steam and in what way China needs to move to a growth model that is driven more by efficiency and domestic consumption. It is not going to happen over night and we will still see investments in natural resources – especially oil and gas – because there is still a lot of urbanizing to be done. Also, if demand growth is not as fast as in the past there will still be a need for imports of copper, iron ore, oil and natural gas.

The pace however will be much slower and both companies as well as the government that oversees them want smarter investments. They will not continue to simply go out and get the resources at any cost. In contrast, they want companies to make smart investment and hopefully there will be smarter deal making by the companies. Due to the slowdown at home, Chinese construction companies are looking for opportunities elsewhere around the world. This is obviously going to push them to places in both emerging and developed economies. Regarding emerging economies Africa comes to mind, a place that still needs a lot of infrastructure development for economic growth. At the same time there is also the U.S. in need of infrastructure investments. A very interesting report by the Rhodium Group is focused on investment opportunities for Chinese companies in the U.S. [14] Their report has a very conservative estimate of tens of trillions of dollars that needed to be invested in infrastructure including energy, transportation, and electricity during the next 20 years. The report makes the case that this actually is an opportunity for Chinese construction companies because – setting aside the growth model discussions – there is a sense that these companies don’t want to put all their eggs in one basket. I would suspect they look at the U.S. the way the NOCs have. Politically it can be tough to get in the door because when you get off on the wrong foot, there can be all sorts of opposition. However, once the deal is closed you don’t have to worry. The U.S. is a good place to do business.

Another challenge will be regarding air pollution in China. My sense is that air pollution is a more urgent issue for the government than climate change. Given the terrible air in Beijing during the first quarter of last year and the end of the year in Harbin and Shanghai, the question is whether a tipping point has been reached where we see more effort put behind measures to clean up the air. Some of my colleagues here who talk to very high-ranking people in China said it is a top priority and they are really looking for methods to tackle air pollution. That is what I would be looking for in the energy sphere. It looks like there was some of that seen last year when Sinopec came out and said they were finally going to upgrade their refineries. We haven’t heard anything from CNPC and they are the ones who have to pay more to upgrade their own refineries. On this issue, there was a great piece in the New York Times where they interviewed Fu from Sinopec and he was saying they always wanted to upgrade, but they didn’t know who was going to pay for it. [15]

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Thank you very much for the interview.

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[1] More about Erica S. Downs at: http://www.brookings.edu/experts/downse.
[2] The shale energy boom in the U.S. and how this impacts Chinese energy security was also addressed by Erica S. Downs in the Brookings blog. To find out more about her takes on this issue, go to: http://www.brookings.edu/blogs/up-front/posts/2013/11/07-shale-energy-revolution-china-downs More on this also in his contribution: “China and Venezuela: Equity Oil and Political Risk” of February 1, 2013: http://carnegietsinghua.org/2013/02/01/china-and-venezuela-equity-oil-and-political-risk/f9y1.
[3] The latest estimates put forward by the U.S. Energy Information Administration can be found at: http://www.eia.gov/countries/cab.cfm?fips=CH.
[4] More on this deal of CNPC in the Financial Times article of July 2, 2013: http://www.ft.com/intl/cms/s/0/58c1a322-e326-11e2-9bb2-00144feabdc0.html – axzz2rR4BDbso.
[5] PetroChina bought control of a Canadian oil sands project in early 2012. More on the background to this deal at: http://www.reuters.com/article/2012/01/03/us-athabasca-idUSTRE8020OW20120103. In the Santos basin offshore Brazil, Petrobras Brasilieiro SA holds 40% in the consortium, Royal Dutch Shell PLC 20%, Total SA 20%, CNPC 10% and China National Offshore Oil Corp. (CNOOC) 10%. More on this bid in the Oil&Gas Journal: http://www.ogj.com/articles/2013/10/libra-presalt-rights-awarded-offshore-brazil.html.
[6] The article can be found at: http://online.wsj.com/news/articles/SB10001424052970204883304577223083067806776.
[7] The deal of CNOOC and Awilco was made in mid 2008. More on it at: http://online.wsj.com/news/articles/SB121540045677831831.
[8] The Stockholm International Peace Research Institute (SIPRI) reported on February 12, 2012 on the challenges China is facing in protecting its overseas citizens: http://www.sipri.org/media/newsletter/essay/february12.
[9] http://www.brookings.edu/research/papers/2013/02/21-china-afghanistan-downs.
[10] Andrew Kennedy is Senior Lecturer at the Crawford School of Public Policy at the Australian National University. He has a forthcoming paper in the Political Science Quarterly about “China and the Free Rider Problem: Exploring the Case of Energy Security.” More on his research at: https://crawford.anu.edu.au/people/academic/andrew-kennedy.
[11] An overview over the way the U.S. and China cooperate in Afghanistan as well as the mentioned statement by Pan Yifang, board secretary of JCCL is available at: http://online.wsj.com/news/articles/SB124545705106832957.
[12] More on the losses of MCC: http://www.chinadaily.com.cn/bizchina/2012-10/16/content_15820348.htm.
[13] More on the speech in which Wang Yi announced that China wants to cooperate with all the countries in the Middle East not only in the economic field, but also in the political, security and military field, can be found at the website of the Ministry of Foreign Affairs: http://www.fmprc.gov.cn/eng/wjb/wjbz/2461/t1116498.shtml.
[14] The Report on Chinese FDI in the U.S. by Thilo Hanemann and Cassie Gao can be accessed at: http://rhg.com/notes/chinese-fdi-in-the-us-2013-recap-and-2014-outlook.
[15] The mentioned article on the measures taken to tackle air pollution and on the discussions about upgrading refineries is available at: http://www.nytimes.com/2013/03/22/world/asia/as-chinas-environmental-woes-worsen-infighting-emerges-as-biggest-obstacle.html?pagewanted=all&_r=0.

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