At the peak of China's oil dilemma

China is battling to stay onside with the US while also ensuring its energy needs are met. And with Iran a key supplier, that won't be easy.

Chinese Premier Wen Jiabao is in the midst of a six-day visit to Saudi Arabia, Qatar and the United Arab Emirates, the first major overseas visit by Chinese leadership in 2012. The focus of the trip is investment, trade and Chinese energy security, reflecting the continued strategic importance of the region in China's energy mix.

The Chinese premier's visit comes as the United States is lobbying for an expansion of sanctions on Iran – again targeting Iranian oil exports – and amid heightened tensions around the Strait of Hormuz as Iran postures to counter US pressure. China receives just under half its imported oil from the Gulf region – including 10 per cent from Iran alone – and while political instability can increase the costs of imports, a more significant disruption in supplies from the region would have a serious impact on the Chinese economy. As part of China's effort to diversify and secure its energy sources – especially given the current tension surrounding Iran and the strait – Beijing intends to boost economic ties with the Gulf nations through investments in energy and other types of infrastructure.

Wen's visit to Saudi Arabia is the first by a Chinese premier in two decades (though President Hu Jintao did visit in 2006 and 2009). His visit to the United Arab Emirates and Qatar is the first by a Chinese premier since China established diplomatic relations with those countries. This lack of visits does not mean China has had no interest in the region, and Chinese businesses have been active in investing in the Middle East countries, but it does showcase the limited interaction between China's top leadership and the Gulf Arab states. Beijing currently has limited influence in the region aside from its economic heft and its permanent seat on the UN Security Council. China has long taken a relatively hands-off approach to the region, largely because it has been the purview of the United States, but also because Beijing has focused much of its attention on developing and expanding additional sources of supplies beyond the Middle East, particularly in Africa and Central Asia.

Wen's main mission is to strengthen economic ties with the Gulf Arab states in order to expand Chinese investment opportunities not only in the region's oil and natural gas sector, but also in railways, ports and other infrastructure. This allows China to take advantage of the continued domestic development in the region, driven largely by petrodollars, and to help shape such developments to create alternative routes for Gulf oil to reach export markets.

Key to this is finding ways to bypass the Strait of Hormuz, the strategic chokepoint at the mouth of the Persian Gulf. Nearly all regional exports must transit the strait – and as Tehran has made clear once again with its recent military exercises, if Iran is pressed too hard, it has the ability to attempt to temporarily block the strait in a crisis, cutting off oil supplies not only to China but to the world. While such a scenario may seem unlikely, and one that would backfire and hurt Iran as much as its neighbours, Beijing sees its oil security in terms of the potential disruptions, not necessarily only in what it considers likely at present.

One of the key projects for China in the region is the Abu Dhabi Crude Oil Pipeline, which would allow tankers to load outside the Strait of Hormuz. This may be a small start, but it demonstrates the type of development China would like to expand regionally. And it is not only in the Middle East where China is participating in or proposing energy supply lines that bypass strategic naval chokepoints. China's pipeline projects in Myanmar, for example, are designed to bypass the Strait of Malacca, and its investments in Central Asia and work with Russia provide additional routes for oil and natural gas imports; these are attempts to limit Beijing's vulnerabilities to any single potential point of crisis or failure.

Any regional instability has the potential to impact China's oil supplies, but Iran brings an additional political risk. In the past when the United States would pressure for increased sanctions against Iran, China would temporarily reduce its imports from Iran, only to build back up again in a month or two. This has allowed Beijing to soften direct US pressure on China and wait for the political environment to cool down before resuming its regular flow of imports. China has neither the political desire nor the economic ability to walk away from Iran, despite US pressure, but it does adjust its monthly imports at times as part of its overall management of US relations.

In part, we are seeing a similar pattern currently as China has reduced its order for crude oil from Iran for January and February compared to its December imports. But this move by China also reflects a debate over the price for Iranian crude for 2012. Beijing, perceiving rising pressure on Iran and moves by Europe to potentially expand sanctions against Iranian crude, has asked for a lower price point and a longer period in which to make payments. As Iran's single largest customer for oil exports, Beijing wields a fair amount of influence in Iran, but with Iran making up more than 10 per cent of Chinese oil imports, Tehran is not without its own leverage and has refused thus far to adjust the payment terms.

In the near-term, China is making up for the decreased Iranian crude by ordering additional supplies from Iraq, Russia and West Africa. But it is unlikely that either Iran or China will hold out indefinitely from finding a compromise and reshaping the terms of their energy deal. And China's increased public attention, investments and work toward a free trade deal with the Gulf Arab states may also serve Beijing in reminding Iran that although it is an important source of Chinese crude, China remains one of Iran's few international defenders – at least politically – and this special relationship with Iran could slip, similar to the change in Chinese relations with North Korea when Beijing established diplomatic relations and expanded economic ties with South Korea.

While it would certainly be difficult to replace Iranian crude supplies, China is focused more on finding additional supplies to fill its expanding consumption. The Gulf Arab states have been a critical component of this, as have increased supplies from Central Asia and Africa, and China anticipates increased Russian supplies. Barring a significant change in the political environment, however, Iran is unlikely to export much more oil to China, as the necessary additional infrastructure development in Iran is not likely to be built any time soon. This means that, while China is not necessarily reducing its overall imports from Iran, Iran will make up a smaller portion of China's energy imports as overall imports expand. Reprinted with permission of STRATFOR.

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