China's rapid rise to become the world's second-largest petroleum user has understandably raised concerns among the country's leaders about its ability to secure the oil supplies it needs to sustain the current economic boom. These leaders worry that the world has entered a prolonged period of tight energy supplies and high prices, and their response has been to send China's national oil companies on a multibillion-dollar global shopping spree for petroleum reserves. A much more efficient and less costly strategy would be to reform the state-controlled petroleum sector, open it to foreign investment, and integrate the country into the global system that supplies Japan, the United States, and other big energy consumers.

This growing appetite for oil is propelled largely by the new love of the emerging Chinese middle class: the automobile. In 2006 China became the world's second-largest auto market, with sales of more than 5 million vehicles. By 2015 more than 100 million cars could be plying the country's roads. Demand for gasoline and diesel fuel is likely to grow by 6 percent a year, and Chinese oil imports will rise from three million barrels a day at present to ten million barrels a day by 2020Ñas much as the United States now imports.

Yet domestic crude-oil production has stagnated for almost a decade, and existing fields are approaching the end of their useful life. Moreover, the Chinese oil companies' fragmented portfolio of domestic reserves is expensive to operate and yields limited amounts of oil, in part because of outdated technologies. China also lacks sufficient refining capacity and is a net importer of fuel oil, high-quality gasoline, and lubricants. To keep up with surging demand, the country needs to build a large, technologically world-class refinery every year for the next 15 years, at a cost of about $2 billion apiece. But government controls on the price of gasoline, diesel,and other such products squeeze refining margins and discourage investment. Although fuel prices have risen by 20 percent since the beginning of 2005, that pace lags far behind the 50 percent increase in international crude-oil prices over the same period.¹ Chinese refiners lost money last year, despite government subsidies. In addition, China's inefficient oil terminals lack the capacity to handle the growing volume of imported fuel.

In an attempt to solve these problems, the big state-controlled oil companies have scoured the world for new resources. To that end, they have spent more than $15 billion over the past five years to acquire more than 100 foreign oil fields and companies. Some of those purchases have strained relations with other countries, notably those that view China's dealings as a source of support for the controversial policies of energy-rich states like Iran and Sudan. As China's strategy of amassing reserves has become more and more clear, the purchases have also heightened concerns about energy security in other major oil-consuming countries.

Ultimately, however, China's investments in foreign oil reserves likely won't fill the energy gap. Even if the country's oil companies succeed in maintaining domestic production at today's levelsÑa tall orderÑthey would have to acquire an additional seven billion tons of foreign oil to meet projected demand from now until 2025. That is the equivalent of 3 percent of the world's known petroleum reserves, or more than the combined reserves of BP, Chevron, ExxonMobil, Royal Dutch Shell, and Total.

And even if it were possible to buy all the reserves China is likely to need, the investment probably wouldn't be a smart one. On average, the country's national oil companies pay at least 10 percent more for foreign reserves than major international oil companies do. This premium indicates that China will pay significantly more for the reserves it purchases than it would if it just bought the supply it needs on international markets. In addition, the foreign reserves of the national oil companies are generally in risky locations where wars or sociopolitical upheavals could interrupt the flow of petroleum. That puts a dent in China's energy security.

Eliminate protections

Liberalizing the sector and integrating China into global petroleum markets would be a far more effective way to ensure that the country has the energy it needs for the future. This approach would certainly be difficult to implement and politically sensitive, but it could be undertaken without compromising the government's right to regulate the sector or relinquishing sovereignty over a strategic industry.

As a first step, the government must stop shielding China's national oil companies from competition. In refining, for instance, the rules require at least 50 percent local ownership, so outsiders can't secure a controlling interest. In fuel retailing, foreigners are limited to 50 filling stations, hopelessly short of what it would take to compete effectively with the market leader, China Petroleum & Chemical (Sinopec), which has more than 30,000. Domestic oil and gas exploration is restricted to the national oil companies, with the exception of a few production-sharing arrangements and joint ventures that have foreigners as minority partners.

The government should remove these protections and encourage private domestic and foreign players to enter China's energy sector. It recently took a small step in that direction by creating an additional state-owned oil company, Shaanxi Yanchang Petroleum, and by approving the formation of a private company, Great United Petroleum Company (GUPC). But much more is needed to foster true competition. To give the national oil companies time to adjust, protections could be lifted graduallyÑfor example, by raising the number of filling stations foreign companies can own to 100, then 500, and so on. The government should also gradually sever ownership and management ties with the national oil companies, allowing them to base their decisions on business strategy and profitability rather than state policy.

Deregulate prices

To make the domestic energy market more efficient, China must deregulate fuel prices, which are currently set using nontransparent criteria. As a result of this system, it is impossible for companies to predict reliably whether investments in refineries or retail networks are likely to be profitableÑa big deterrent to new entrants. The government should replace the current controls with a clearly defined, transparent system that pegs fuel prices to the cost of oil on international markets. To protect farmers and other groups that might suffer from a large price increase, policy makers could institute tax breaks or special grants to assist them.

Although the government is expected to reform the pricing system this year, the large gap between international oil prices and what Chinese consumers pay at the pump makes full liberalization unlikely. Nonetheless, policy makers must establish a clear path to reach that goal within two or three years. Again, a step-by-step approach would ease the transition.

China certainly faces obstacles to opening its energy market to outside competition. One of the toughest may be resistance from the national oil companies, which naturally don't want powerful new rivals on their turf. But if international companies participated broadly in China's domestic oil industryÑfrom exploration and refining right down to the filling stationÑcompetition would spur the national oil companies to become more efficient. The experience of Russia's oil industry suggests that foreign participation would also provide the technology to help extract more oil from China's mature fields, thereby boosting domestic production by at least 10 percent a year. Energy-rich countries and international oil companies might be enticed to swap partial ownership in their reserves for access to China's huge retail market. Moreover, an open, vibrant Chinese energy industry could increase overall economic growth by 1 to 1.5 percentage points annually and foster the development of a global energy hub to rival Houston or Aberdeen.

The Chinese government's track record in liberalizing other industries, including autos, steel, and telecommunications equipment, shows that liberalization is both possible and desirable. In each case, China allowed competition to increase progressively by reducing tariffs and quotas, relaxing investment constraints, and attracting much-needed know-how. Those industries are stronger as a resultÑand the energy industry would be as well.