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South China Sea flare-up bodes ill for oil and gas operators

South China Sea flare-up bodes ill for oil and gas operators

The recent diplomatic clash between China and Vietnam over deep-water exploration in the South China Sea has important implications for oil and gas companies with interests in disputed waters. In July, China reportedly threatened Vietnam with a limited military response if Hanoi did not immediately withdraw permission granted to a foreign oil company to conduct exploration activities in waters claimed by Beijing. 

The incident reinforces the suggestion that Beijing’s strategically ambiguous claims in the South China Sea have evolved to encompass perceived rights to oil and gas resources located within its nine-dash line. Beijing appears ready to use a combination of largess, threats and direct action to prevent South-East Asian states from developing such resources unilaterally, even if China is in no rush to develop them for itself due to commercial and geopolitical factors. 

Investors with interests in acreage located within disputed waters will have to weigh up the risk posed to their operations both by China directly and host governments lacking the resolve to stand up to Beijing’s increasingly assertive posturing. 

Hydrocarbon exploration triggers backlash from Beijing

Recent tensions in the South China Sea centre on Block 136/03, which lies on the outer edge of Vietnam’s exclusive economic zone (EEZ) and is licensed by Hanoi to a consortium led by Spain’s Repsol. Crucially, the block is also located within China’s vaguely demarcated nine-dash line, used as the basis for Beijing’s historical claim to maritime rights and resources throughout much of the South China Sea (See Map: South China Sea). Indeed, China licensed the same acreage in 1992, although there is a deal of confusion over who currently owns the exploitation rights.

Wary of antagonising its northern neighbour, the government in Hanoi has avoided exploration activities in the area since the HD-981 drilling rig incident in mid-2014: when Beijing directed China National Offshore Oil Corporation (CNOOC) to use a deep-water rig to conduct exploratory drilling in an area straddling two hydrocarbon blocks demarcated by Vietnam. The move sparked a six-week maritime standoff and marked a low point in contemporary Sino-Vietnamese relations. 

Nevertheless, following a period of relative calm in the South China Sea in the first half of 2017, Hanoi felt secure enough to give Repsol the green light in June to conduct drilling work in Block 136/03. Although details remain officially unconfirmed, Beijing reportedly responded by threatening Hanoi with military action against Vietnamese outposts in the Spratly Islands (which are themselves the subject of various overlapping sovereignty claims) unless all oil and gas activity in the block ceased immediately. After a hastily convened Politburo meeting, and with little signs of public support from Washington, Hanoi capitulated to Beijing’s demands and requested that Repsol cease its activities and leave the area. 

The Block 136/03 case study adds to our understanding of the commercial risk landscape in the South China Sea on a number of fronts. 

Beijing’s claims encompass perceived rights to oil and gas resources 

Firstly, the Block 136/03 incident supports a maximalist interpretation of what exactly China claims in the South China Sea, something that Beijing has not precisely articulated to-date. In other words, Beijing now appears to consider its nine-dash line, the legality of which was struck down by the Permanent Court of Arbitration in July 2016, as conveying rights to oil and gas resources situated within it. Rather than simply conveying sovereignty over land features and their corresponding maritime zone for example. 

Such a hard-line interpretation has concerning implications for a number of South-East Asia states that are seeking to develop hydrocarbon resources in waters claimed by Beijing, including Vietnam, Malaysia, Indonesia, Brunei and the Philippines; not to mention the operators that hold rights to such blocks. 

Beijing is concentrating on shaping future developments 

Secondly, Beijing’s bellicose response to exploratory drilling in Block 136/03 raises the potential that China is now seeking to oppose, dissuade or disrupt any new attempt by South-East Asian government to unilaterally develop hydrocarbon resources located within its nine-dash line. 

A key test of China’s intent will be the progress Repsol makes in developing Vietnam’s Red Emperor (Ca Rong Do) oil and gas field in Block 07/03, which neighbours Block 136/03. A final investment decision on the project was taken in April 2017, with development drilling set to be carried out in 2019. The more high-profile Blue Whale (Ca Voi Xanh) gas field may prove a less useful data point. The field itself does not appear to be in disputed waters, even if a portion of the block it sits within, and Exxon Mobil’s wider exploration rights, includes acreage bisected by Beijing’s claim. 

According to our sister company Wood Mackenzie, 62 oil and gas fields located within the nine-dash line are already producing under the authority of various South-East Asian states. To-date, the development of these resources has not been the focus of China’s coercive behaviour. This would support the argument that Beijing is concentrating on shaping future developments rather than seeking to overturn what is a fait accompli.

Another point of interest is that China is in no rush to develop hydrocarbon resources in disputed areas of the South China Sea, but appears content to prevent others from doing so at this stage. The reason for this lack of urgency is likely because 71.2% of the total discovered reserves located within China’s nine-dash line are not currently considered commercially viable. 

However, there is also a geopolitical angle to this lack of development. The 2014 HD-981 rig incident was an embarrassing setback for China, as CNOOC was forced to beat an early retreat in the face of Vietnamese resistance. Since then, Beijing has been more cautious about conducting oil and gas activities in disputed waters. Indeed, Wood Mackenzie data shows that Chinese NOCs have refrained from conducting exploratory drilling within the nine dash line since July 2014, aside from within waters that China could reasonably claim under the UN Convention on the Law of the Sea. 

Threat of military reprisals raises stakes 

Thirdly, while Beijing’s use of coercion to prevent oil and gas development in disputed waters is not new, the Block 136/03 case further underscores Beijing’s willingness to take, or at least threaten, direct action to enforce its perceived rights. The situation has led states such as Vietnam and Indonesia to respectively deploy, or announce an intention to deploy, naval assets to protect off-shore drilling activities from disruption. Yet blurring the lines between commercial and naval activities in this way raises the potential for oil and gas assets to become targets in any militarised confrontation. 

The threat of military reprisals against a country that fails to toe Beijing’s line in the South China Sea marks a worrying escalation. However, the Block 136/03 case is not an isolated one. President Roderigo Duterte of the Philippines told reporters earlier this year that his Chinese counterpart, Xi Jinping, had threatened war if Manila went ahead and unilaterally drilled for oil around Reed Bank – an area where Beijing’s claim overlaps with the Philippines’ EEZ.

It remains to be seen if Manila will go ahead and risk Beijing’s ire by including blocks situated in disputed waters as part of a mooted licensing round slated for December, but China’s shot across the bows will be hard to ignore. Another option is for Duterte to concede to Beijing’s demand to pursue ‘joint development’, although that scenario will likely run into political roadblocks at home. 

Key takeaways for operators 

Companies with interests in blocks licensed by South-East Asian governments but located within waters claimed by Beijing are likely to face pressure directly from China not to undertake any development. There are a number of potential consequences for firms that ignore China’s protestations. 

These include on-site harassment by Chinese maritime vessels, de facto exclusion from the Chinese market, right through to implicit threats to company staff and assets à la BP’s reported experience in 2007. The latter is thought to have been one of the contributing factors to the company’s decision to exit Vietnam’s offshore blocks 05-2 and 05-3.

Even investors willing to front the risk posed by Beijing’s increasingly assertive posture may run into trouble. Operators also have to analyse the resolve of South-East Asian governments to stand up to China. Otherwise, companies with rights to develop blocks or fields in disputed waters may find that they are prevented from exercising them, as host government become wary of rocking the boat. Conversely, states that are committed to securing their maritime rights will likely provide increased support to operators to expedite development.

By Hugo Brennan, Asia Analyst at Verisk Maplecroft

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