A crude point of view

A little over a decade ago officials from the Organisation of Petroleum Exporting Countries (OPEC) were talking glumly about oil prices falling as low as $22 a barrel.

Meeting in Algiers in February 2004 to coordinate a production cut, ministers were fearful of the risks ahead. “Every piece of paper we had indicates we are going into a glut,” one predicted. “The price can fall, and there is no bottom to it,” warned another.

But the slump never happened and the reason was China. Its coal-fired power stations couldn’t provide enough energy for its surging economy and oil was the only readily available alternative. The subsequent ‘demand shock’ had a startling impact on prices, writes Daniel Yergin in The Quest: Energy, Security and the Remaking of the Modern World.

Chinese consumption of crude grew 16% that year, much faster than the overall economy, launching a four-year period in which global oil prices went on a tear.

As ministers from OPEC countries met in Vienna this week they seemed blindsided once again – this time by an unforeseen plunge in oil prices. Brent crude, the key international grade, has dropped close to $70 a barrel, its lowest price in four years, and down more than 30% from its June high. Ten years on from the ‘demand shock’, what is China’s role in the latest oil crisis? And is it going to prosper or be punished in the volatile market?

What’s causing the slump?

One reason is that weak economic conditions are forcing down the price of crude. Poorly performing Europe is a major culprit, although the impact from the slowdown in China may be greater because it is the key contributor to increases in oil demand (accounting for a third of the growth last year, according to the US Energy Information Administration).

China is already the world’s second-largest consumer of oil and it imports almost 60% of its supply. So producers have watched anxiously as its economy decelerates, growing at its slowest pace in five years in the third quarter, with fixed asset investment slowing to a 13-year low.

Weaker growth has thrown up some surprising statistics. For example, the Chinese have been net exporters of fuel for four months of this year. Part of that is due to expansion in local refining. However, China’s broader importance to global oil prices was confirmed again last Friday when its central bank surprised markets by lowering interest rates. Crude reacted quickly, climbing 1.3% on hopes that the cut would boost growth.

This is a different mood to that witnessed for most of the last decade, when oil prices were spurred ahead by emerging markets. There was a brief slump after the financial crisis in 2008, but prices soon recovered, and they have been averaging about $100 a barrel since 2011.

China led much of the charge, with demand increasing by 5% or 6% a year. By last year it was slowing down, with Reuters pegging the increase at 1.6%. That was the weakest in six years, and less than the growth from the United States, which reversed years of decline by increasing its own uptake by 2%, or 390,000 barrels a day.

It seems to have taken time for the realities of the slowdown to sink in. The International Energy Agency (IEA) has been forced to reduce its forecasts for Chinese demand five times this year, for instance. But there is growing understanding that demand from an economy expanding by 7% (and probably less) isn’t going to be as exciting as when growth was double digit.

At its bleakest, this view puts crude in the same category as many of the other commodities that have come to the end of their ‘China boom’. Oil has finished its super-cycle, just like coal, zinc, nickel and iron ore before it.

But aren’t the price declines more about oil supply?

China’s slowdown has been gradual rather than dramatic. So by itself, it doesn’t explain the sudden deterioration in oil prices (declines that have been “nothing short of remarkable”, the IEA said in September).

In fact, most commentators believe that it is changes in supply that are responsible for most of the current volatility in prices, especially the three million new barrels a day being generated from America’s shale reserves.

“For 10 years, the defining factor in the oil market was the growth of China and Chinese oil demand. Now the defining factor is the astonishing growth of US oil production,” says Yergin, who is also vice chairman of energy researcher IHS.

This new stream of supply from fracking ‘unconventional basins’ like Eagle Ford in Texas and the Bakken in North Dakota helped lift American production to nine million barrels a day at the start of November, the most since 1983.

Critics say the boom won’t last because America’s shale wells are too quickly exhausted and that the slump in the oil price will put a natural brake on investment in more of them.

But in the meantime the oil price is plummeting, fracturing the finances of many producer nations.

Isn’t China benefiting, as a consumer?

When prices fall, producers generally miss out, while consumers gain. And as a leading importer of oil, China looks set to prosper. According to The Economist, every $1 fall in the oil price approximates to $2.1 billion in yearly savings, so the declines could deliver a financial benefit of $60 billion this year.

The Chinese have also been taking the opportunity to stock up on cheaper crude. Since January, total imports have averaged 6.1 million barrels per day.

Much of this build-up has come in the last three months as Beijing bolsters its strategic reserves. Supertanker arrivals at Chinese ports breached new records last month, Bloomberg reports, while OPEC’s latest estimate is that the Chinese have added at least 35 million barrels to their inventories.

Last week the Chinese authorities also released the first-ever formal estimate for state petroleum reserves, with the National Bureau of Statistics identifying supplies of about 91 million barrels of oil across four different locations.

This is some way short of the 90 days of oil generally cited as an acceptable backstop (about 600 million barrels of crude in China’s case). Maybe that means that more buying is likely if prices stay low. But reserves may be greater than the official numbers suggest as the stockpile doesn’t include the commercial reserves held by the state-controlled oil giants (which Tom Reed, editor at Petroleum Argus, estimated at about 260 million barrels in the Financial Times last week).

And how about the geopolitics?

Oil at $80 a barrel is casting a disruptive shadow across producer nations, especially those who can’t balance their budgets at current prices.

Chinese strategists have long been uncomfortable about their own reliance on foreign oil, of course. That doesn’t look like changing. Last month the China Development Research Centre of the State Council – China’s cabinet – published a report warning that three quarters of its oil supply will need to be imported by 2030, because of the mismatch between local demand and local production.

In the short term the lower prices might ease some of the anxiety. At least China is in a better shape than Russia, where sales of oil and gas account for about half of the national budget. Rows with the Americans and the Europeans over the situation in Ukraine don’t help and the plunge in prices is likely to push the Russians closer to China as they look for alternative markets for their natural resources.

The Chinese will sense weakness and try to strike better deals.

The oil crisis has also seen Venezuela grow more reliant on Chinese largesse, with news that Caracas transferred $4 billion of an earlier loan commitment to its central bank last week in an effort to shore up its finances.

But from Beijing’s perspective it’s the geopolitical reverberations of the shale revolution that could have the biggest impact. If its shale boom can be sustained, the US could become the world’s largest oil producer by 2020, the IEA has predicted, and may even achieve energy self-sufficiency by 2035. How could this impact China? Some forecast it could be a catalyst for a US manufacturing revival as American firms rediscover their strengths in industries previously surrendered to lower-cost rivals. American factories are already getting cheaper power than their international competitors. The chemicals sector is another early beneficiary, sourcing cheaper gas as feedstock for plastics and polymers. But champions of the shale boom say the next phase of the energy revolution is going to feed into lower costs for a much wider range of manufacturers. That could take American firms to the cusp of an industrial renaissance in which they strike back at competitors from other markets, including Chinese ones.

This optimism contrasts with much slower progress in exploiting shale in China (see WiC207), which led the State Council to cut its fracking production targets for 2020 by a third last week. Policymakers have tried to inject more urgency into the sector but the high-profile deals to import Russian gas and the drop in the price of crude have dampened the enthusiasm for shale among the domestic energy giants.

Chinese shale is proving more difficult to frack too. “The geographical environment is more complex and we can’t get the technology and the experience from the Americans easily,” Gao Bingqi, deputy director of the Gas Resources Research Centre, told China Resource News. “And much of the shale is in the north of the country, which is facing a water shortage. Water is the necessary condition for developing shale oil. So there is still a long way to go for shale oil in China.”

So how are China’s oil firms faring?

Often forgotten is China’s sizeable domestic production of conventional oil, about four million barrels a day, the fourth largest after Saudi Arabia, Russia and the US.

Obviously, it’s not in the interests of its oil majors to see prices slumping, especially when many of their projects are aging or in geologically complex places.

All three Chinese majors announced lower profits at the end of October in their most recent results, with the impact felt across the supply chain. PetroChina – the listed arm of CNPC, China’s largest oil producer – saw profits fall 6.2% year-on-year, although CNOOC is more immediately exposed to falling prices, because it is the most reliant on revenues from upstream activity, mostly in offshore drilling.

It doesn’t publish quarterly earnings but Zhong Hua, its chief financial officer, reported that revenues had fallen 4.6%, admitting too that its budget for the year had been predicated on an oil price of $102.

“Oil price falls will affect all of our projects for sure,” Zhong said, adding that it will hold off on some of its highest-cost projects, including deepwater exploration overseas.

Sinopec – the third of China’s oil triumvirate – is also suffering, despite earning more of its income in oil refining and the sale of finished products like fuel. Posting a 12% fall in third quarter profits, it complained of weaker refining margins amid slowing demand. That seems a little counterintuitive as you might expect cheaper oil to lead to better profits on diesel and gasoline. But refiners suffer in volatile markets by being forced to revalue the oil they have stockpiled. Sinopec is also caught up in a pricing lag, paying for crude on contracts agreed months ago but selling fuel against a formula that sets prices according to international benchmarks, which change more frequently. (Another reduction in China’s diesel price is expected today.)

The downturn comes at a time when all three are under scrutiny, with anti-graft investigations into some of the ‘oil faction’ bosses, as well as pressure to open up more of the industry to private companies (see WiC211).

A greater sense of caution has also been evident in investment activity, where oil bosses have been taking a breather this year, announcing only Sinopec’s buyout of a stake in Kazakhstan’s Caspian Investment Resources for $1.2 billion in April, and CNPC’s purchase of 10% of an eastern Siberian field in September for an undisclosed fee.

Compare that to the frantic dealmaking of the previous two years in which at least $40 billion of business was reported, headlined by CNOOC’s $15.1 billion swoop for Canada’s Nexen.

A lot of those takeovers now look expensive, says Yen Ling Song, an analyst at energy research house Platts. She estimates that oil and gas production from overseas assets now exceeds two million barrels of oil equivalent a day, because of the investment spree. But much of the spending happened when oil was at $110 a barrel, Song says, and doesn’t make the same financial sense when prices are closer to $80.

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