Russia’s largest oil company state-owned Rosneft started drilling at a natural gas at a field off of Vietnam’s coast and cross one of Beijing’s red lines in the process.

The once close relations between China and Rosneft seem to be cooling. While they have been pulled together to face down the American hegemon, their own interests are not perfectly aligned and frictions are starting to show.

China has made claims on the Vietnamese piece of seabed, and the Kremlin back away from a row by explaining Rosneft had not consulted with it regarding the decision to drill. Beijing’s criticism caught the Kremlin off-guard. It had not lodged any criticism earlier when Rosneft [launched] exploratory drilling at the field, which began in 2016.

China appears to be pushing against Rosneft’s ambitions to develop offshore projects not only to secure its own maritime claims. The move parallels Russian oil companies’ dependence on China as a result of western sanctions on imports of certain technologies meant for offshore oil projects.

The story highlights the costs of Moscow’s turn towards Beijing for political support.

Rosneft and China

Rosneft and its CEO Igor Sechin is Russia’s leading company in its economic diplomacy with China. Closer cooperation between Rosneft and China’s National Petroleum Corporation (CNPC) and Sinopec – China’s largest state energy firms – goes back to 2013.

That year, Rosneft acquired domestic competitor TNK-BP and its oil assets in Russia’s east for $55bn to surpass ExxonMobil and become the world’s largest listed oil producer. Rosneft owed $71bn in debt after the deal went through.

China was looking to buy into oilfields in Russia. Rosneft saw an opening and agreed to double oil supplies to China using TNK-BP’s assets. The company received an estimated $60bn prepayment for future oil deliveries, cash it used to pay debts.

Rosneft depended on financing from China, but offered few opportunities to invest into Russian oilfields in return.

Rosneft spurns CNPC

In the next big deal Sechin sold a 19.5% stake in his company at the end of 2016 to China in what was hailed at the time as the largest Chinese investment into Russia ever. The deal was intended to raise billions of dollars to close a RUB2 trillion hole in the budget and had no other means of raising cash following the financial sanctions imposed by the west in 2014. He went into a consortium between the Qatar Investment Authority (QIA) and commodities trader Glencore.

CNPC had missed a chance to acquire a large stake of a Russian state firm, but the privatization was completely opaque raising questions over what exactly happened. The privately-owned company China Energy Company (CEFC) smelled an opening.

CEFC signed large supply deals with Rosneft in the second half of 2017 but the “privatisation” turned out to be more of a loan and CEFC eventually moved to acquire roughly 14.2% of Rosneft’s shares from those acquired by QIA and Glencore for around $10bn in a “real” deal.

Things fall apart

Chinese ownership of such a large stake of Russia’s oil champion would have cemented Russia’s fastest expanding oil trading relationship. But CEFC CEO Ye Jianming was investigated for economic crimes in late February, casting doubt on the deal.

By May, doubts were replaced with the certainty that the deal was off. CEFC’s Shanghai subsidiary defaulted on some of its debts after news emerged that the company was not taking part in the deal for shares. CEFC’s investments in central Europe, and in Czechia in particular, have also since fallen to pieces.

Rosneft may have overextended itself by pursuing such a large deal with a privately-owned company, as normally Beijing would prefer state-owned firms to buy stakes of foreign companies. Neither CNPC or Sinopec expressed any interest in stepping into the breach as the deal with CEFC fell apart despite the clear political benefits, which should raise red flags in Moscow.

Their lack of interest forced Rosneft’s hand. It sold the 14.2% stake to QIA and has changing its corporate spending plans to improve returns for shareholders. The whole saga reflects problems posed by sanctions.

The Effect of Financial Sanctions

Western financial sanctions on Rosneft forced the company to jump through hoops to shield the sale of shares. It also meant that no western oil firms could feasibly make offers given the scrutiny they’d receive from the US Treasury’s Office of Foreign Assets Control (OFAC). Rosneft has become a toxic asset for western investors, which can now be penalised for doing any sort of business with the Russian hydrocarbon behemoth.

The company was also cut off from access to western capital markets, forcing it to take out a record amount of debt domestically to finance operations. Russian state-owned bank VTB had to lend Rosneft $11bn to finance the privatization deal.

Profitable expansion abroad is necessary for the company’s bottom line. It can only borrow so much in Russia where sanctions limit opportunities.

The Effect of Technology Sanctions

Rosneft is also hobbled by the technological sanctions. These developments parallel problems facing Rosneft regarding access to advance[d] drilling technology. Since 2014, Western sanctions on Russian firms’ import of technology and services for oil projects has interrupted Arctic offshore oil development plans

That’s huge since over half of the Russian Arctic’s oil reserves are offshore.

Russia relies on imports for over 80% of its technological needs for offshore oil projects, mostly from the US and EU. Chinese firms have moved in to the market in response.

But China’s gear can’t yet replace that of western firms for the many of the Arctic’s technically complicated projects. Further, Chinese offers of financing for energy projects often include stipulations forcing Russian firms to buy Chinese equipment.

Vietnam and Japan’s Role in Rosneft’s Strategy

This is where Japan and Vietnam come in.

Rosneft is looking to gain experience working offshore in Vietnam to advance its international expansion plans. It needs to go abroad for opportunities to develop projects offshore given how difficult it is to work in the Arctic, without the proper gear.

Rosneft is leasing equipment from Japanese firms for its work in Vietnam. Cooperating more closely with Japan in particular could alleviate a growing dependence on China’s technology and replace western imports.  

Russia has also actively sought to diversify its economic and political relationships across the Asia-Pacific since 2013. Vietnam fits into a broader push into Southeast Asia’s oil sector, Russia’s strongest card to deepen economic ties.

China’s ready to push back

Russia remains officially neutral on the status of the South China Sea so that it can pursue closer ties with a wide range of regional partners, including Vietnam to whom it exports weapons and has enjoyed close ties with since Soviet times.

China’s Ministry of Foreign Affairs spokesman Lu Kang urged the countries and companies involved to “respect China’s sovereign and jurisdictional rights.” That’s a big shift from opting for silence over drilling activities conducted in maritime territory China claimed before 2016.

Broader Sino-Russian relations won’t take a large hit over the development, but Russia’s ability to pursue its interests in Vietnam independent of Beijing has been curbed

China is now willing to push back on projects in the South China Sea of vital interest to Russia’s biggest taxpayer and its oil strategy. That can’t be comfortable for the Kremlin.