CHINA: Surging oil demand changes energy scene

Analysis

China's demand for oil grew by 9% in 2003 to about 270 million tonnes. This represents a doubling of total oil consumption since 1992. Meanwhile, domestic oil production remained almost static last year at 170 million tonnes, up barely 20% on 1992. The resulting deficit was filled by net imports of about 100 million tonnes -- three times the level in 1998. Gross imports totalled 120 million tonnes, of which crude oil accounted for 90 million tonnes, up 30% from 2002.

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Demand drivers. The sudden surge in demand for oil has been driven by four phenomena:

• Total vehicle sales in China reached 4 million in 2003 -- double the 1999 level -- and much of this growth has come from the sale of private cars.
• A significant proportion of last year's 9.1% GDP growth was a result of government-stimulated activity in heavy industry, which remains an important user of oil.
• Electricity shortages in many provinces drove industrial and commercial users back to relying on oil-fuelled generators.
• After several years of procrastination, the government finally agreed on a strategy for developing a strategic oil stockpile, which is intended to reach 10 million tonnes by 2005 and 22 million tonnes by 2010.

Within the next two years it is likely that the rate of growth of demand for oil will decline slightly, not least because of the lack of infrastructure in China to import, refine and distribute oil. Indeed, local shortages of certain products were being reported by the end of last year (see CHINA: Shortages underline incoherent energy policy - January 26, 2004). In the longer term, as long as economic growth remains in its historical range of 6-10%, it is probable that demand for oil will continue to grow at 5% or more per year. This would take annual consumption to 400 million tonnes by 2010 and some 600 million tonnes by 2020 (the latter figure representing more than double Japan's current consumption and some two-thirds of US consumption). With domestic oil production set to reach a plateau in the near future, net imports will continue to rise, reaching as much as 400 million tonnes by 2020.

State control. Most consumers of oil in China are in the private or quasi-private sector, acting in a more or less competitive environment, but the oil industry remains under strong government control. Most production, refining and distribution of oil is controlled by the two state oil giants, PetroChina and Sinopec, and the central government sets ranges for both wholesale and consumer oil prices. In addition, the import and export of crude oil and oil products are subject to licences issued by the government.

China's accession to the WTO is forcing a staged relaxation of these controls, and foreign players have already been able to play a marginal and growing role in China's domestic oil market. Although state control allows the government to maintain a grip on oil strategy, it is also a source of weakness. For example :

• neither global price rises nor domestic shortages are allowed to create prompt pricing signals to producers or consumers; and
• as a result, export and import patterns react slowly to the domestic market, and consumers are not encouraged to constrain their consumption.

Supply security. Beijing's approach to security of energy supply is based on a distrust of international energy markets and a preference for self-reliance. It focuses on direct political and economic action by the government and state companies. The key elements of official strategy have been to invest in overseas oil resources; to build political relations with a wide range of oil exporting nations; to maximise domestic production; and to construct pipelines from oil fields in neighbouring countries (see AFRICA/CHINA: Beijing eyes energy and extends reach - February 6, 2004).

While considerable progress has been made on the first two items, it is far from clear that these gestures will secure China's oil supplies during a crisis. Efforts to raise China's domestic oil production are falling far short of their targets, mainly for geological reasons. Meanwhile, the construction of major international oil pipelines has been delayed by political uncertainty in the case of Russia and by cost in the case of Kazakhstan (see CHINA: Beijing ponders Russian reliability post-Yukos - November 25, 2003). Only recently has China announced a plan to develop strategic oil storage to cope with short-term supply crises. The latest component of China's oil security strategy is a project to develop an industrial-scale plant to produce oil directly from coal.

Demand policy. Little effort has been expended on constraining demand. Policies for energy efficiency and energy conservation in recent years have proved to be strong on rhetoric but weak in implementation. The transport sector is an extreme example: the government has positively encouraged the development of road transport, rather than rail; has encouraged private car ownership; and has generally failed to develop coherent urban transport strategies (see CHINA: Beijing wrestles with infrastructure challenge - February 18, 2004). Moreover, attempts to introduce a significant tax on transport fuels have been thwarted for several years.

Investor implications. Events and trends in China's oil sector have implications for a range of foreign companies:

• There are clearly long-term opportunities for oil traders, or producers selling directly to China. China's oil imports are set to rise for the foreseeable future and WTO compliance requires Beijing to relax its controls over imports.
• The refining and distribution sector are opening slowly, but PetroChina has been preparing well for the competitive onslaught. There are unlikely to be easy pickings in the first few years unless the government intervenes to stop abuse of monopoly positions.
• Vehicle manufacturers appear convinced that growth in demand for private cars will accelerate, and continue to invest heavily in plants in China.

However, trends in China's energy sector are rarely linear. Unpredictable events within the domestic market or unpredictable government actions can result in wild fluctuations of supply, demand or import, as can simple infrastructure bottlenecks. Those foreign investors in China that are major consumers of oil could find that supplies are not as reliable as they might have hoped. On a wider scale, players in the international oil markets will increasingly need to understand China's domestic oil market in order to appreciate and forecast its impact on international oil prices.