Can China Keep the Lights On? More cars on its roads, more air conditioners in its homes, more factories pumping out products. To keep its economy humming, China is scouring the globe for oil--and roiling the world's energy markets in the process.
By Clay Chandler Reporter Associates Helen Kim, Annie Wong

(FORTUNE Magazine) – When Chinese troops opened fire on Soviet counterparts at a border checkpoint in 1969, the shots reverberated across the oilfields of Daqing. For much of the decade, a cadre of Chinese geologists and engineers, tutored by Soviet technicians, had struggled to coax crude oil from Daqing's frozen prairies. With the border skirmish, Sino-Soviet relations collapsed. Moscow ordered its experts home. Wang Qimin, then one of Daqing's youngest engineers and now its most senior, still bristles when he remembers the Russians' taunts as they departed. "They mocked us," he recalls. "They said, 'Your methods are too primitive. Trying to develop Chinese oilfields without Russian expertise is as futile as trying to learn how to make a shirt by studying a piece of cloth.' "

Wang and his compatriots proved the Russians wrong. In the years that followed they raised Daqing's capacity to more than a million barrels of oil a day, an astounding feat that enabled Mao Zedong to thumb his nose at the Soviets--and the rest of the world--for years. Today Daqing, China's largest oilfield, is a sprawling state-run colossus: 90,000 workers tending 50,000 wells linked by a maze of pipelines and storage tanks across an 800-square-mile expanse in the northeastern corner of the country. In the city of Daqing itself, hundreds of rusting pumps bob methodically--beside government office buildings, behind restaurants and karaoke bars, and in the midst of dingy housing blocks.

But China's moment of energy independence is over. After years of drilling, China's main oilfields are badly depleted. Costs per barrel have crept up steadily. At Daqing annual output has fallen 12%, to 50 million tons, since production peaked in 1997. As domestic reserves dwindle, China's economy, which grew at a sizzling rate of 9.1% last year, is shifting into overdrive. With the engines of consumption, business investment, and government spending all running full throttle, China, an oil exporter only a decade ago, has acquired a voracious appetite for foreign crude.

Since 1990 oil consumption has jumped by an average of 7% a year. Last year China guzzled 5.4 million barrels a day, eclipsing Japan as the world's second-largest oil consumer, though still far behind the U.S., at 20.2 million barrels a day. Imports topped two million barrels a day, a third higher than in 2002. The International Energy Agency (IEA) in Paris predicts that by 2030 imports will account for 85% of China's total oil consumption.

China's hunger for oil and other forms of energy poses far-reaching challenges for Beijing and the global economy. Already China competes with the U.S., Japan, and Europe for oil from the Middle East. Bear Stearns energy analyst Adam Clarke cites surging Chinese demand as the "primary factor" behind OPEC's success in preventing a collapse in oil prices in the wake of a U.S. victory in Iraq. Says Cambridge Energy Research Associates chairman Daniel Yergin: "Growth in Chinese demand is a fundamental trend driving world oil markets today. People used to talk about China's oil needs in passing. Now it's the No. 1 topic."

There's more at stake than just high oil prices. Security experts fear that China's determination to minimize dependence on oil from the Middle East, where the U.S. has strong ties to major producers, will tempt Beijing into oil-for-arms alliances with states the U.S. accuses of sponsoring terrorists. Environmentalists worry that to slow dependence on foreign oil, China will renege on commitments to curb reliance on coal. (China now counts on coal for 70% of its total energy needs and is the world's largest producer of carbon emissions.) Beijing might also embark on an expansion of its nuclear energy program--a troubling prospect given China's abysmal industrial safety record. Investors, meanwhile, fret that Chinese leaders will prod state-run energy firms to squander capital on unproductive overseas oil assets or overspend on grandiose pipeline projects to transfer energy from China's resource-rich western provinces to its booming eastern seaboard.

China's leaders know that in the long run, failure to come to grips with rising energy needs will jeopardize growth. For now, though, they're scrambling just to keep the lights on. Last summer an unexpected spike in electricity demand wiped out large swaths of China's power grid, plunging scores of cities into darkness and forcing temporary closure of thousands of factories. As many as two-thirds of China's provinces suffered severe power outages. In Shanghai last month shopping malls were ordered to turn down their thermostats. In Changsha, the capital of Hunan province, authorities have limited electricity use to three days a week.

The shortages highlight Beijing's reluctance to loosen its grip on the Chinese economy. Bureaucrats at the National Development and Reform Commission dictate who can build new power plants, how much they can charge for electricity, and how much they pay for the coal and diesel fuel needed to produce it. But planners have consistently misjudged demand, forecasting a 5% rise in electricity usage last year when actual growth jumped 15%. The NDRC has commissioned a flurry of new power-generation projects, among them the Three Gorges Dam. But it will be several years before those new facilities yield enough additional capacity to meet China's needs, and it's far from clear that new juice can be delivered flexibly and reliably after they come online.

The power shortages reflect the "complete incoherence" of China's approach to energy policy, says Philip Andrews-Speed, a former BP executive who heads an energy policy institute at Scotland's University of Dundee. China's leaders deem energy issues too important to leave to the market, he says, but they haven't figured out an alternative mechanism to make sure energy gets where it's needed, when it's needed. "There's no energy ministry, no center for decision-making, no one place responsible for pulling it all together," says Andrews-Speed. "Different strands of the energy question thread through a tangle of different offices. Companies and agencies fight it out at the highest levels." The result? "Systems break down, monopolists block distribution, power stations don't get built, and there are no price signals to guide investors on where to invest."

That's a fair assessment, agrees Chen Fengying, research director at the China Institute of Contemporary International Relations. "Each company and industry pushes its own priorities," she says. "No one authority is in charge."

Beijing's mismanagement of the nation's power grid hardly inspires confidence in official projections about China's oil needs. The government's Energy Research Institute sees oil consumption rising to seven million barrels a day by 2010. That squares with IEA estimates, but the agency's most recent forecast assumes China's GDP growth will slip to 4.8% in coming decades--a good two percentage points below the consensus of private economists. Analysts at Cambridge Energy put 2010 oil consumption at eight million barrels a day, while Bear Stearns's Clarke thinks the figure will be closer to 13 million. With per capita income rising above the $1,000 mark, he says, China has reached a crucial "inflection point" and is poised for explosive growth in energy demand.

In China's largest cities, passenger car sales, which leaped 55% last year, have spawned near-permanent gridlock. Industry experts predict similar growth this year as car prices fall and Chinese banks and foreign carmakers expand financing programs for would-be drivers. Meanwhile consumers throng the aisles of stores selling appliances. And the spread of television, with its constant barrage of advertisements and foreign programs, has kindled a yearning for consumer goods in even the remotest rural villages.

China imports about 60% of its oil from the Middle East. That vexes China's leaders not only because the region is a bastion of U.S. influence but also because it's unstable. Worse, tankers carrying oil to China from the Middle East must pass through chokepoints that leave China vulnerable to blockade by the U.S. in the event of a showdown over Taiwan.

Beijing has worked frantically to secure alternative oil supplies--but with mixed results. Last May, Chinese President Hu Jintao traveled to Moscow to endorse a 25-year, $150 billion contract between state-owned China National Petroleum and Russia's Yukos Oil. The deal envisioned construction of 1,500-mile pipeline capable of moving as much as 600,000 barrels of oil a day from oilfields in eastern Siberia to Daqing. From there it could be pumped to the rest of China. But the plan foundered in October, when Yukos CEO Mikhail Khodorkovsky was hauled off to jail and charged with tax evasion. The fall of Khodorkovsky, who had clashed with Russian President Vladimir Putin, enabled Japanese officials to advance a counterproposal to build a longer, larger pipeline skirting China and connecting to the Pacific port of Nakhodka. Tokyo is offering $7.5 billion in financing for the project and has promised development loans for the Russian Far East. It's not feasible to build both pipelines, and Putin isn't likely to pick a winner until after Russian elections in March. But his aides have talked up the Japanese proposal in recent weeks, noting that it would give Russia access to markets in Japan, South Korea, and elsewhere in East Asia.

Hu also paid a visit to Kazakhstan to back another oil deal, this one calling for a pipeline to transport oil from the Caspian Sea to western China. But hopes for that project dimmed when a consortium of Western and Japanese oil companies blocked China's efforts to secure additional drilling rights in the region.

With the two pipelines looking increasingly like pipe dreams, China's oil companies are scouring the globe in search of oilfields they can buy. In recent years they have made investments in Sudan, Kazakhstan, Indonesia, and Australia. But so far those acquisitions have yielded only about 200,000 of barrels of oil a day in new capacity--a drop in the ocean of China's projected needs. They've earned China a reputation for overpaying for unproven energy assets and squandering capital that could have been spent buying oil on the spot market. Japan pursued a similar plant-the-flag approach to energy security after the 1979 Arab oil embargo. But the policy was a fiasco, leaving the government holding $20 billion in unrecoverable loans to companies that bought unproductive wells abroad. These days the Japanese, who count on imports for 98% of their oil needs, have come to live with the notion that they're better off buying oil than buying oil wells.

That's a proposition China's leaders aren't ready to swallow. Instead they have opted to inject competition in manageable doses. In the late 1990s, Beijing restructured the nation's oil production and refining institutions into two competing giants, each with drilling and refining assets and separate distribution networks. The two enterprises shed millions of unneeded workers, scrapped some of their least profitable operations, and hired Western banks to help dress up subsidiaries for listing on exchanges in Hong Kong and New York. A third company, China National Offshore Oil Corp., was given primary offshore drilling and development rights. Subsidiaries of the two onshore oil firms, PetroChina and Sinopec, fetched $7.5 billion in offerings to foreign investors.

One of those investors was Warren Buffett, who last year spent an estimated $500 million for a 13% stake in PetroChina. At PetroChina's Beijing headquarters, president Chen Geng says that although he has never met the Sage of Omaha, he welcomes his investment. Chen, who holds PetroChina stock options himself, proclaims Buffett's investment a "wise decision"--and with the stock price up 133% since his purchase, it's hard to disagree.

But the effort to instill private-sector sensibilities goes only so far. Between gulps from a jar of tea, Chen stresses that PetroChina's most important shareholder is the Chinese government, not Warren Buffett. Visitors to Daqing get a carefully orchestrated tour of "model pumping stations" and well-scrubbed research facilities. Even the tiniest attempt to depart from a preset itinerary meets resistance from official escorts.

Daqing's patron saint is Ironman Wang, an illiterate peasant revered for proclaiming that he would gladly sacrifice 20 years of his life to find more oil for China. In the Ironman Wang Museum, sepia photos show him leaping into a slurry pit to mix cement with his own body in an effort to plug a ruptured well. Mao lionized Wang as a revolutionary hero, and in official folklore Daqing came to symbolize the idea that through hard work and a commitment to socialist principles, China's people could bend nature to their will--without help from outsiders. But those lessons are out of step with China's current predicament. To keep growing, China will need more than hard work and revolutionary zeal--it will need all the outside assistance it can get. "People got all worked up when we started importing oil in 1993," says Wang Qimin, the Daqing engineer hailed by many as Ironman's successor. "But I see it as a sign that we've matured. We're so big now, we grow so fast. As long as we make money from exports, why not buy oil from the Middle East?"

One place where China could benefit from outside help is in developing reserves of natural gas, which currently supplies only 3% of the country's energy needs. Foreign capital might also finance the extensive network of pipelines needed to transport that gas from western provinces to eastern factories.

Western oil giants have long angled for a role in China's domestic energy markets. But with the exception of WTO concessions granting some rights to operate gas stations in China, Beijing has held the Western majors at bay. Mark Qiu, a former investment banker who is now CNOOC's chief financial officer, argues that China "has no choice" but to reach out to Western multinationals. "They're the big producers," he says. "They have the discovery and production technologies. They're the ones who make markets. We have to create an incentive for their partnership--and that means letting them make a profit."

For now, though, the drivers of China's economy seem determined to stick to the self-service pump, even if they have to pay more for the privilege.