Depends on who you ask, there are signs that the friction in the oil rich South China Sea may be abating. Tensions seem to be easing in the short term, with nothing resolved to the long-term problem of border demarcation. Two countries in particular have been China’s main thorn in their quest to claim the entire sweep of the South China Sea – Vietnam and the Philippines – and in its dealings with both of them, China is rewarding cooperation and punishing dissidence.
Last month, Vietnam ordered Spanish firm Repsol to halt work on its Ca Rong Do (Red Emperor), where commercial drilling was imminent, later asking it to declare ‘force majeure’ following pressure from China. It is the second major cancellation in the southern Nam Con Son basin – which skirts China’s nine-dashed line – and could cost Repsol and partners some US$200 million in sunk investment. Vietnam has been vocal about pursuing its own energy agenda, but in the end, ended up having to kowtow to China.
The Philippines has also loudly proclaimed sovereignty over its part of the South China Sea, going as far as to bring the case to UNCLOS, which ruled in favour of the Philippines in a 2016 verdict that China refuses to recognise. However, since then, President Duterte has made cordial overtures to joint developments. While both sides have reiterated that joint oil and gas exploration will not affect their legal positions. The Philippines announced last week that cooperation was moving ahead after both countries claimed to recognise and accept each other’s ‘firm red lines’. It by no means settles the issue in the long run – indeed, successive governments could reverse the position – but it paves way for resources to be developed like in the Thailand-Malaysia Joint Development Area, legally unsettled but commercially viable. In choosing to engage, China has seemingly rewarded the Philippines with a mutually beneficial arrangement, a stance that it has not taken with the more belligerent Vietnam.
That’s not the best outcome, though, as the issue of maritime borders is still unsettled. China has always favoured bilateral talks with each of the claimants to the South China Sea – Malaysia, Indonesia and Brunei included – a divide and conquer strategy that allows it to throw its weight around. But with the USA absent to exert pressure for encompassing solution, favoured by the Obama administration but ignored by Trump, the countries of the South China Sea rim are sitting ducks against the might of China. Either they capitulate – and are rewarded with some crumbs – like the Philippines; or they defy – and end up capitulating anyway with nothing to show – like Vietnam. The vibe in the South China Sea may be seemingly calmer right now, but there are still dangerous currents beneath the surface.
The Current Weather Forecast: China and the South China Sea Nations
Vietnam – Choppy. China has been pressuring Vietnam to halt fishing and upstream activity.
The Philippines – Calmer. China has agreed to joint development of hydrocarbon resources
Malaysia – Calm. No clashes yet, but Malaysia controls part of the disputed Spratly islands.
Brunei – Calm. No clashes yet, but Brunei claims part of the disputed Spratly islands.
Indonesia – Choppy. No clashes yet, but Indonesia claims the waters around the Natuna islands are its ‘traditional fishing grounds’, effectively re-naming it “North Natuna Sea”
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International expansions for Saudi Aramco – the largest oil company in the world – are not uncommon. But up to this point, those expansions have followed a certain logic: to create entrenched demand for Saudi crude in the world’s largest consuming markets. But Saudi champion’s latest expansion move defies, or perhaps, changes that logic, as Aramco returns to Europe. And not just any part of Europe, but Eastern Europe – an area of the world dominated by Russia – as Saudi Aramco acquires downstream assets from Poland’s PKN Orlen and signs quite a significant crude supply deal. How is this important? Let us examine.
First, the deal itself and its history. As part of the current Polish government’s plan to strengthen its national ‘crown jewels’ in line with its more nationalistic stance, state energy firm PKN Orlen announced plans to purchase its fellow Polish rival (and also state-owned) Grupa Lotos. The outright purchase fell afoul of EU anti-competition rules, which meant that PKN Orlen had to divest some Lotos assets in order to win approval of the deal. Some of the Lotos assets – including 417 fuel stations – are being sold to Hungary’s MOL, which will also sign a long-term fuel supply agreement with PKN Orlen for the newly-acquired sites, while PKN Orlen will gain fuel retail assets in Hungary and Slovakia as part of the deal. But, more interestingly, PKN Orlen has chosen to sell a 30% stake in the Lotos Gdansk refinery in Poland (with a crude processing capacity of 210,000 bd) to Saudi Aramco, alongside a stake in a fuel logistic subsidiary and jet fuel joint venture supply arrangement between Lotos and BP. In return, PKN Orlen will also sign a long-term contract to purchase between 200,000-337,000 b/d of crude from Aramco, which is an addition to the current contract for 100,000 b/d of Saudi crude that already exists. At a maximum, that figure will cover more than half of Poland’s crude oil requirements, but PKN Orlen has also said that it plans to direct some of that new supply to several of its other refineries elsewhere in Lithuania and the Czech Republic.
For Saudi Aramco, this is very interesting. While Aramco has always been a presence in Europe as a major crude supplier, its expansion plans over the past decade have been focused elsewhere. In the US, where it acquired full ownership of the Motiva joint venture from Shell in 2017. In doing so, it acquired control of Port Arthur, the largest refinery in North America, and has been on a petrochemicals-focused expansion since. In Asia, where Aramco has been busy creating significant nodes for its crude – in China, in India and in Malaysia (to serve the Southeast Asia and facilitate trade). And at home, where the focus has on expanding refining and petrochemical capacity, and strengthen its natural gas position. So this expansion in Europe – a mature market with a low ceiling for growth, even in Eastern Europe, is interesting. Why Poland, and not East or southern Africa? The answer seems fairly obvious: Russia.
The current era of relatively peaceful cooperation between Saudi Arabia and Russia in the oil sphere is recent. Very recent. It was not too long ago that Saudi Arabia and Russia were locked in a crude price war, which had devastating consequences, and ultimately led to the détente through OPEC+ that presaged an unprecedented supply control deal. That was through necessity, as the world faced the far ranging impact of the Covid-19 pandemic. But remove that lens of cooperation, and Saudi Arabia and Russia are actual rivals. With the current supply easing strategy through OPEC+ gradually coming to an end, this could remove the need for the that club (by say 2H 2022). And with Russia not being part of OPEC itself – where Saudi Arabia is the kingpin – cooperation is no longer necessary once the world returns to normality.
So the Polish deal is canny. In a statement, Aramco stated that ‘the investments will widen (our) presence in the European downstream sector and further expand (our) crude imports into Poland, which aligns with PKN Orlen’s strategy of diversifying its energy supplies’. Which hints at the other geopolitical aspect in play. Europe’s major reliance on Russia for its crude and natural gas has been a minefield – see the recent price chaos in the European natural gas markets – and countries that were formally under the Soviet sphere of influence have been trying to wean themselves off reliance from a politically unpredictable neighbour. Poland’s current disillusion with EU membership (at least from the ruling party) are well-documented, but its entanglement with Russia is existential. The Cold War is not more than 30 years gone.
For Saudi Aramco, the move aligns with its desire to optimise export sales from its Red Sea-facing terminals Yanbu, Jeddah, Shuqaiq and Rabigh, which have closer access to Europe through the Suez Canal. It is for the same reason that Aramco’s trading subsidiary ATC recently signed a deal with German refiner/trader Klesch Group for a 3-year supply of 110,000 b/d crude. It would seem that Saudi Arabia is anticipating an eventual end to the OPEC+ era of cooperative and a return to rivalry. And in a rivalry, that means having to make power moves. The PKN Orlen deal is a power move, since it brings Aramco squarely in Russia’s backyard, directly displacing Russian market share. Not just in Poland, but in other markets as well. And with a geopolitical situation that is fragile – see the recent tensions about Russian military build-up at the Ukrainian borders – that plays into Aramco’s hands. European sales make up only a fraction of the daily flotilla of Saudi crude to enters international markets, but even though European consumption is in structural decline, there are still volumes required.
How will Russia react? Politically, it is on the backfoot, but its entrenched positions in Europe allows it to hold plenty of sway. European reservations about the Putin administration and climate change goals do not detract from commercial reality that Europe needs energy now. The debate of the Nord Stream 2 pipeline is proof of that. Russian crude freed up from being directed to Eastern Europe means a surplus to sell elsewhere. Which means that Russia will be looking at deals with other countries and refiners, possibly in markets with Aramco is dominant. That level of tension won’t be seen for a while – these deals takes months and years to complete – but we can certainly expect that agitation to be reflected in upcoming OPEC+ discussions. The club recently endorsed another expected 400,000 b/d of supply easing for January. Reading the tea leaves – of which the PKN Orlen is one – makes it sound like there will not be much more cooperation beyond April, once the supply deal is anticipated to end.
End of Article
- Crude price trading range: Brent – US$86-88/b, WTI – US$84-86/b
- Crude oil benchmarks globally continue their gain streak for a fifth week, as the market bounces back from the lows seen in early December as the threat of the Omicron virus variant fades and signs point to tightening balances on strong consumption
- This could set the stage for US$100/b oil by midyear – as predicted by several key analysts – as consumption rebounds ahead of summer travel and OPEC+ remains locked into its gradual consumption easing schedule
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