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Jul 25, 2012 | 10:00 GMT

7 mins read

Hydrocarbon Exploration and Politics in the South China Sea

Hydrocarbon Exploration and Politics in the South China Sea
ROSLAN RAHMAN/AFP/Getty Images
Summary

China's state-owned China National Offshore Oil Corp. issued a takeover bid July 23 for Canadian energy company Nexen. The $15.1 billion offer, if approved by the Canadian government, would increase the Chinese firm's technical capabilities by giving it access to offshore-drilling technology being used in the North Sea and in the Gulf of Mexico.

In a region with numerous overlapping territorial claims, such as the South China Sea, the search for additional hydrocarbon reserves is about more than energy acquisition. As countries continue vying for control of the South China Sea, hydrocarbon exploration and production can lead to territorial claims. However, there is risk in exploring in the South China Sea, and continued slow progress toward exploration in deeper waters could eventually make hydrocarbon exploration of limited political use for smaller countries. Countries that rely on joint ventures for the necessary technology will be subject to market conditions for further exploration. China — the one country currently making progress toward unilateral capabilities — could continue to use hydrocarbon exploration as a political tool, regardless of the risk and time involved.

Activity in the South China Sea, on both the military and energy fronts, has increased in recent months. Recent actions, including the launch of a new domestic deep-sea drilling vessel and the auctioning of blocks in disputed waters, illustrate China's proactive approach to using energy exploration as a political tool to claim territory.

Risks and Obstacles

Reported estimates for the South China Sea place reserves of oil at 21.6 billion barrels and of natural gas at 8.5 trillion cubic meters. However, in the absence of information from exploratory drilling, these estimates rely heavily on geological information used to calculate resources in unexplored areas. Additionally, the reported numbers are simply the mean of an estimated range of potential reserves (8.9 billion to 41.6 billion barrels and 3.7 trillion cubic meters to 15.8 trillion cubic meters). Chinese estimates are actually much higher, exceeding 200 billion barrels of oil. These reserve estimates often change after initial exploration.

The uncertainty over the amount of hydrocarbons present makes investment in unproven areas such as large portions of the South China Sea a risky proposition. There is a huge difference between fighting for resources thought to be there and competing for resources actually coming out of the ground.

The Outer Continental Shelf of the Gulf of Mexico provides a good example of the potential costs of failure. Initial rough estimates indicated more than $9 billion a year would be required to develop regions that had been closed to exploration for decades. Even in fields about which significant information was known, such as the Tahiti field, it would take several years to develop the infrastructure necessary for exploration. The first estimates showed that the Tahiti field might require an investment of $4.7 billion before the first dollar of profit would be seen. The first stage of the field, completed in 2009, was a $2.7 billion investment. When the numbers are this high, it is extremely risky to make a financial investment based on little hard data.

Progress into deeper waters of the South China Sea has been slow, partly because of regional tensions. Energy exploration and production in the South China Sea has remained close to the shores of controlling regional bodies and away from disputed areas for the past 40 years. In other offshore areas, such operations have expanded into deeper waters in the same time frame.

The high potential for hydrocarbon recovery in the area is known, so the lack of exploration could be attributed to several factors, including political and financial risks. There have been examples of success in recent years, including promising results from the Liwan natural gas field through collaboration between Canadian firm Husky Energy and the China National Offshore Oil Corp. However, a failed or dry deepwater well can cost a company tens of millions of dollars. If the number of new exploratory wells in deeper waters remains limited, so will the acquisition of new reserve estimates based on exploration. Thus, investment in the area will continue to be risky.

072412 Map - South China Sea Energy

The farther from shore hydrocarbon sources are located, the greater the need is for additional technology that allows the platform and drilling equipment to withstand the harsher conditions of deeper waters. Semisubmersible rigs and drill ships are the most commonly used rigs in deepwater exploration and production. These rigs must be stabilized at the surface of the water, through traditional mooring or dynamic positioning systems. 

China National Offshore Oil Corp. recently finished construction on and began drilling with its first domestic deepwater-capable semisubmersible rig, CNOOC 981. Smaller countries, such as Vietnam and the Philippines, still rely on international cooperation for deepwater drilling, because these countries lack the technological capabilities necessary for exploration in deeper waters. This may require the leasing of a rig. The daily cost of a semisubmersible rig or a drill ship required for deepwater drilling is two to 10 times more than the daily costs for an offshore rig capable of shallow-water operations. The cost of a drill rig also depends greatly on market forces, because limits on the availability of drill rigs can increase the daily costs for producers.

Other Countries' Options

For nations in the region, territorial claims can take precedence over the actual energy resource. For example, China can use its drilling capabilities to stake claims on disputed areas without going to war. The presence of Chinese assets in the region, the assumption goes, will result in de facto control and legitimate use of the water to supply any rigs present. The cost of failed rigs could be rationalized as a territorial acquisition cost.

As China continues to develop its technological capabilities through domestic development and acquisitions of foreign companies such Nexen, Vietnam, the Philippines and other countries are placed in a weaker position. However, they retain several options. One is to work with China, an option that, by Beijing's calculation, would solidify its claims on the region via a physical presence. Another option is to enter into joint ventures with third parties. However, this second option works only when there is incentive for investment. That is, the region needs to actually contain hydrocarbons in order for this strategy to work in the long run, unless the joint partner becomes politically motivated as well.

Forum Energy, a subsidiary of Philippines-based Philex Petroleum, appears to at least be considering the first option. As of late June, the firm was still considering a potential partnership with China National Offshore Oil Corp. to explore areas of the Reed Bank in disputed waters. However, the Philippine Department of Energy is set to receive bids on blocks in a similar region at the end of July. 

Vietnam appears to be using the second option; it has been able to find third-party countries and companies willing to cooperate on projects. India announced July 18 that Indian energy firm Oil and Natural Gas Corp. Videsh Ltd. would continue exploring Block 128, even though it had already abandoned a block in the same region due to poor performance. Remaining in the region could indicate a political motivation on India's part. Gazprom and ExxonMobil had also been active in the region and Italy's ENI also recently agreed to conduct exploration activities off the coast of Vietnam. The political situation does not yet appear to be adversely affecting investment.

Smaller countries in the region have a third option: developing independent technology much as China did. Vietnamese energy companies own a few shallow-water rigs and plan to invest $600 million over the next four years into rigs. However, China has a significant head start, and joint ventures are still the most viable short-term option.

Politics and China's Primacy

In addition to the possibility of poor performance, escalation in political tensions could cause international companies to withdraw from projects in the South China Sea. Exploration is financially risky to begin with, and regional disputes would only increase that risk. Countries such as India and Japan might have an interest in the South China Sea and may remain there longer because they are politically motivated to thwart China's advances in the region. Political motivation as a factor in exploration efforts should not be ignored and could provide an alternative motivation for financing and bringing in necessary partnerships for smaller countries in the South China Sea region.

However, China is the only country with territorial claims in the South China Sea that currently possesses the technology required for deep-sea operations. China may deem the cost of a failed well worth the political gain of securing a broader maritime buffer and thus Beijing may continue exploration beyond where it is financially viable. Until further exploration is conducted and more information is known about the deeper waters of the South China Sea, reserve estimates will not be established enough to mitigate the higher risk of exploration posed by the potential escalation of political tensions for parties with only financial interests in such operations. Until then, China appears to have the upper hand in using energy as a geopolitical tool in the South China Sea.

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