By Brian Bremner in Hong Kong and Dexter Roberts in Beijing, with Adam Aston in New York, Stanley Reed in London, and Jason Bush in Moscow

For a sense of just how vast China’s energy needs are, take in the night views from the observation deck of Shanghai’s Oriental Pearl Tower. From that perch 263 meters above the city’s streets, you’ll see a spaghetti jumble of bright neon illuminating the colonial-era buildings of the waterfront Bund and the swarms of shoppers on Nanjing Road. Closer at hand, the shiny skyscrapers of Pudong are lit into the night. Across the city, long lines of trucks, buses, and cars clog narrow lanes, broad boulevards, and new elevated expressways. And farther afield, the smokestacks of Shanghai Baosteel Group belch smoke from the tons of coal the forges consume daily, while oil tankers in the harbor unload yet more fuel to keep the city of 20 million humming.

As China’s economy expands, so does its thirst for oil, gas, coal, and electricity. Today, China accounts for 12.1% of the world’s energy consumption. That’s second only to the U.S., at 24%, and up from 9% a decade ago. China’s whole modernization strategy is based on access to abundant supplies of energy. Its hungry basic industries such as steel, aluminum, and chemicals devour electricity and coal. A mushrooming middle class consumes growing quantities of heating oil and gasoline. By 2010 analysts expect some 56 million cars, minivans, and sport-utility vehicles to be rolling on China’s highways — more than twice the number today. By 2020 the country’s demand for oil will nearly double, to 11 million barrels a day, natural gas consumption will more than triple, to 3.6 trillion cubic feet annually, and coal use will grow by 76%, to 2.4 billion tons a year, according to a U.S. Energy Dept. forecast.

That means China will play a key role in influencing global oil prices and energy investment flows — not to mention climate-destabilizing carbon dioxide emissions. “There is going to be a huge increase in consumption across the region, and especially in China,” says Edu Hassing, an energy analyst at the Asian Development Bank.

With China consuming ever more oil, it risks developing an ever-greater dependency on foreign vendors of crude. For the security-obsessed Chinese, that’s pretty scary. Right now, though, it’s hard to see how the Chinese will avoid the same fate as the U.S., which is uncomfortably dependent on oil states such as Nigeria, Saudi Arabia, and Venezuela. Just a decade ago, China was a net exporter of oil, but now it imports 40% of its crude as output declines at the big northeastern fields near Daqing and Liaohe. What about developing new sources at home? China is sitting on potentially rich reserves in the high, dry deserts of the far west, but gas and oil there lie much deeper than in the northeast and will cost far more to get out of the ground. And given the country’s primitive pipeline and transportation networks, moving it to the coastal cities that need it will be a challenge.

Colossal Waste

Meanwhile, China’s power supply and grid haven’t kept pace with demand, compounding the problems created by rising dependency on foreign oil. While power shortages and rationing have been common during recent summers, for the first time ever nine provinces in China are expecting outages this winter. “Energy could be an Achilles’ heel of the government,” says Scott Roberts, director of the China operations of Cambridge Energy Research Associates in Beijing. Adding to the burden — and increasing the need for oil — is a colossal amount of energy waste, thanks to primitive coal-mining techniques, loose building construction codes, and inefficient factories. “The Chinese spend three times as much as the world average on energy to produce $1 of gross domestic product,” says Wenran Jiang, an associate professor at the University of Alberta.

The Chinese know they have a problem, and Premier Wen Jiabao and former Shanghai Mayor Xu Kuangdi, who now heads the Chinese Academy of Engineering, have taken the lead. Last November, the all-powerful State Council issued the broad outlines of a new energy policy through 2020 that called for a “leapfrog strategy in the energy field.” The aims include securing more supplies abroad, shifting away from China’s fixation with coal, dramatically increasing the use of natural gas, building more hydro generators on the mainland’s vast river networks, upgrading the electricity grid, and pushing for more solar and wind power resources.

The plan even calls for a major ramp-up in nuclear energy. Beijing wants to have nearly 40 reactors by 2020, up from nine today. So later this year, China is expected to accept bids for building four 1,000-megawatt pressurized water nuclear reactors. Foreign companies such as Westinghouse Electric of the U.S., Areva and Alstom of France, Mitsubishi of Japan, and Atomic Energy of Canada are all in hot pursuit. China is also handing out fat contracts for conventional power-plant deals, cleaner coal-burning technologies, and wind power. “Growth is happening in all fuel types,” says John Rice, chief executive of GE Energy, which last year nailed about $900 million in contracts to build turbines in China.

What comes through most clearly in this energy scramble, though, is a mounting Chinese obsession with securing — and safeguarding — sufficient oil supplies from around the world. Coal is too polluting to rely on exclusively, and even nuclear energy won’t come to the rescue. The 30 new reactors, when up and running, will kick in only about 4% of the juice the country needs. Oil, meanwhile, fuels China’s cars, buses, and trucks and keeps many of its industrial plants churning out goods.

So the clock is ticking on locking in an oil lifeline that will keep the nation’s supergrowth on track. By 2025, China will probably import 75% of its crude — nearly twice the percentage today — and consume 10.6% of the world’s oil, the U.S. Energy Dept. estimates. Although crude has fallen some from its recent $55-a-barrel high, experts expect Chinese demand will help prop up prices for years to come. And the Chinese know just how vulnerable a country can be when its oil comes from somewhere else. In fact, the military has published a book, called Liberating Taiwan, that imagines Chinese warships seizing sea routes to the Persian Gulf and imposing an oil embargo on Taipei, Tokyo, and Washington.

Beijing wants no such energy cutoff for the mainland. So the Chinese are grabbing what they can — and fending off anyone with a rival claim. The result is a very muscular petrodiplomacy. Look at what’s happening to the Chunxiao natural gas field, which lies largely in Chinese territorial waters on a continental shelf in the East China Sea. Japan says part of the shelf juts into its maritime border extending from the southern island of Okinawa, so Tokyo — also eager for energy — wants its share of the bounty. Too bad: Beijing argues it controls the whole thing. A Chinese exploration group has started drilling there, and plans are being drawn up for a pipeline to spirit the stuff back to the mainland. The two sides attempted to smooth things over in meetings in Beijing on Oct. 26, but they got nowhere. “I don’t know why these talks were even held,” fumed Japan’s Economic Trade & Industry Minister, Shoichi Nakagawa.

Japan and China are also clashing over the route of a pipeline across the dark forests and frozen steppes of Siberia. Tokyo wants Russia to build a pipeline costing as much as $16 billion to the Pacific port of Nakhodka, where the oil could be transferred to tankers and shipped to Japan and other markets. Beijing is seeking a shorter route that would terminate in the Chinese oil town of Daqing. Chinese leaders have bent over backward to outfox Japan and in October even settled a long-standing border dispute with Moscow and promised some $12 billion in business investment in Russia. Yet it’s almost certain that Japan will triumph because a security-obsessed China insists on having full control of the end of the pipeline, and thus Russian oil supplies, within its borders. This Chinese solution would give the Russians zero flexibility in selling their oil to other customers. “It’s like being tied to someone during a knife-fight,” says Ronald Smith, an oil-and-gas analyst at Renaissance Capital in Moscow. Beijing might ultimately accept a pipeline to Nakhodka with a spur to China. That would be far costlier, though, and there are questions whether Russia can produce enough oil to make such a plan viable.

With the Russian pipeline far from a sure thing, China is looking elsewhere. Chinese companies have signed oil or natural gas exploration deals in Australia, Indonesia, Iran, Kazakhstan, Nigeria, Papua New Guinea, and Sudan. So far, these deals represent just 10% of China’s oil imports. Even so, China says they’re important. “China has to look at supply security,” says Mark Qiu, chief financial officer of offshore exploration company CNOOC Ltd., “and the name of the game in energy security is diversification.”

Can Western companies profit from China’s oil obsession? Beijing has for several years pushed for listings of its big oil companies on international markets in order to cement tie-ins with overseas energy producers. The 2000 initial public offering of PetroChina Co., a unit of China National Petroleum Corp., raised about $3 billion globally, and BP PLC quickly snapped up 20% of the shares offered — though it sold its stake this year. In later offerings, ExxonMobil and Royal Dutch/Shell bought pieces of Sinopec, the nation’s refining and distribution giant, and Shell took a stake in CNOOC Ltd.

Iffy Reserves

Initially, the deals looked like a win for both sides. Chinese players would get foreign capital and exploration knowhow to nail new energy reserves, while the Western petromajors would get a foothold in the world’s fastest-growing energy market. It hasn’t worked out that way. This year, Western companies have pulled out of two projects that are critical to China’s energy security: the Chunxiao gas development and the West-East pipeline, a $6 billion project running from the western province of Xinjiang to Shanghai. Part of the problem is that the reserves in both Xinjiang and the East Sea are iffy, something even Chinese oil executives concede.

Another is that there is little economic incentive for the Western oil majors to foot big upfront investments when Beijing has been slow in handing out domestic contracts to foreign players. True, there has been some progress: BP is a 30% partner in a Chinese joint venture to build a $665 million liquid natural gas terminal and storage facility in Guangdong province and runs several hundred gas stations there, while Shell has set up a joint venture with Sinopec to build and operate 500 service stations in Jiangsu province. But Shell was an early participant in the West-East pipeline, only to pull out later. The company says that was for commercial reasons, but others say the benefits of the project would have flown to PetroChina, and that Shell had been denied access to the Chinese market for its own imported gas, as it had hoped when it signed on. “All these firms looked at the West-East gas pipeline as a gateway project,” says Cambridge Energy’s Roberts. “They wanted to leverage the project for political capital that would win them access to other deals.”

To its credit, China is allowing foreigners into the crucial field of controlling pollution. Coal continues to be the source of 70% of the nation’s energy. Many homes still heat with coal, and the mainland’s inefficient power industry is a major polluter and often burns unwashed, high-sulfur coal that spews tons of sulfur dioxide into the atmosphere. China is years behind in adopting cleaner coal-burning technologies such as scrubbers that trap pollutants before they can escape into the air. Last year, the Asian Development Bank found that just 5% of China’s power plants had any serious pollution controls at all.

So China is letting foreign companies that specialize in cleaner-burning techniques, such as turning coal into gas or liquid fuel, start the cleanup. It’s a vast project. China leads the global league tables in sulphur dioxide emission and is home to 16 of the 20 most polluted cities in the world, while cases of respiratory disease are surging. The World Bank (news – web sites) estimates that pollution costs China about $170 billion a year, or 12% of gross domestic product, in lost productivity and health-care costs.

Beijing leaders acknowledge such problems, although they argue it is an inevitable side effect of rapid industrialization that once also bedeviled other regional economies such as Japan. But the Chinese have begun experimenting with an emissions-trading market similar to those in the U.S. and Europe, in which permissible levels of pollution are established and enterprises that can’t meet those targets can buy credits from greener companies. China also surprised critics in July by mandating some of the toughest auto-emission standards going.

That’s encouraging, but it’s only one part of the puzzle. It will take a sustained campaign of conservation, improved energy technologies, more enlightened treatment of Western oil partners, billions in investment, and loads of exploration luck at home and abroad for China to be truly energy secure. For the sake of its future prosperity, China needs to start getting a lot of things right — and quickly.