Russia-China Energy Agreement: The World’s Largest Ever Commercial Deal

The $400 billion, 30-year natural gas deal just announced by China and Russia is the biggest single trade agreement in history. With this deal, Russia has signaled a major and sharp pivot of its economic and strategic focus to Asia.

Russia’s pivot to Asia and dramatically enhanced relations with China, which this deal and related agreements signify, will have substantial long-term implications for Asia and more broadly for the Asia Pacific region.

The largest previous natural gas deal which China has signed was with Australia, a dozen years ago. That was a $25 billion deal and runs through to the end of the next decade. The China-Russia natural gas deal is about 16 times larger.

By any measure, it is a big, big deal. Indeed, it is the single largest trade deal ever.

Long term implications

While perhaps accelerated by recent pressures brought to bear on both Russia and China by the United States, the deal has been a decade in the making — and it has a significance far beyond the immediate time horizon.

Important for Russia, the agreement includes a base price formula with reference to oil prices.

This is something the Chinese side has resisted tenaciously, just as Russia strenuously held out for an oil reference price formula to price the gas supplies. Through negotiations in the past few weeks, and indeed right up to the final agreement, this was the key, final sticking point.

As with Europe, so with China

The pricing of Russia’s very substantial natural gas sales to Europe is based on an oil price reference formula. With oil prices so high, the oil-based price formula for natural gas allows Russia to sell its gas at a higher price than if it were based on spot-market natural gas prices.

Russia has been determined to protect this price formula. Had the country failed to do so with China, Western Europe countries would have immediately demanded a revision of their natural gas supply contracts with Russia. So the agreement is a big breakthrough for Russia.

The two parties have announced that the price will remain a “commercial secret.” However, it is thought that, in exchange for China having finally accepted an oil-related price formula, which it has never done previously, China has negotiated an initial price close to what it has been proposing.

In addition, the agreement includes that Russia cover $70 billion in upfront spending on infrastructure, while China will pay upfront $22 billion. Earlier in the negotiations, Russia had proposed a 55:45 split of upfront commitments.

Russia’s pivot to Asia

The gas will start flowing to China by 2018, which is significant because it is 3-4 years before any North American natural gas would be available for shipment to Asia.

While China’s demand for natural gas will continue to increase, and substantially, for many years to come, this massive deal is a major new element in the equation for those players looking to export North America’s surging shale gas supplies to Asia.

In addition, as part of the agreement, Russia has accepted the doubling of its oil exports to China to approximately a million barrels a day. The two countries also announced during the two days of meetings in Shanghai a number of other agreements.

This includes the joint production of commercial aircraft and heavy helicopters as well as joint developments in petro-chemicals.

These agreements represent a vast upgrading in China-Russia relations. More significantly, they mark a sharp “Pivot to Asia” by Russia.

Next stop for Russia: Japan

But Russia has more on its agenda. Next on the list for Russia is a big energy deal with Japan. Negotiations have been going on for some time. Both sides are working toward an agreement for the visit of President Putin to Japan in September 2014.

Japan is the world’s largest importer of natural gas. It continues to seek to diversify its sources of supply.

Japanese buyers are less focused on price than is China, as they also include in their calculations security of supply, stability of supply and consistency of the composition of imported natural gas. Japan also has accepted an oil reference formula for pricing its natural gas purchases.

At the same time, expectations are building in Japanese political circles that the two countries can come to an agreement later this year on their protracted, and for most outsiders, senseless territorial dispute.

Tokyo hopes are that negotiating the energy deal can be doubled up with an agreement on its territorial claims which date back to the circumstances of Japanese surrender in 1945.

Russia and North Korea?

In addition to the deal with Japan, there is a real curve ball in preparation. Over the last two years, Russia has settled all outstanding commercial issues with North Korea. These touched essentially on the issue of trade debt and other unpaid loans.

Russia accepted to forgive $10.9 billion in outstanding debt, with the remaining $1 billion to be paid in equal instalments over 20 years. In settling these issues, Russia and North Korea have set the base for substantially increased economic relations.

Against this background, Russia’s Gazprom and North Korea’s Ministry of Energy have come to an understanding to build a natural gas pipeline that would enter North Korea at the Khasan crossing of the Tumen River, on the Russian-North Korean border. The pipeline would then extend through North Korea to South Korea (Korean Gas Co).

Russia connects North and South Korea; East and West hemispheres

Tantalizing, in what shapes up to be a new case of Russian “gas diplomacy,” this supply line would supply both North and South Korea. This project has been discussed for more than a decade, with much of the initial impetus coming from South Korea.

But it is Russia that has moved into the driver’s seat in the last two years. A related project would see a modern rail line built from South though North Korea into Russia, and then connecting to the Trans-Siberian Railway. Even more fascinating, this would allow high-speed rail connections directly from South Korea to the markets of Europe.

If such a natural gas line and railway were to be built — and there is strong support for this in parts of the South Korean establishment and business community — it would not only provide South Korean producers direct land access across Central Asia and all of Europe.

It would also provide the impetus for transforming the North Korean economy — and change that region’s frozen geopolitics in the process.

In short, if its vision comes to pass, Russia would become anchored in Asia as it never has been in the past. Better yet for Moscow, all major economies of East Asia would become linked to Russia in a way few had previously imagined possible. And that would be truly a pivot to Asia.

That also means that Russia will become enmeshed in East Asia in ways which will pose new challenges for Russia itself.