China: Where a price shock could hit the hardest

During the waning months of 2010, demand for diesel fuel in China took a mysterious and unexpected spike.

The sudden increase in the need for the oil product left many experts perplexed. Why was the use of diesel, which had been relatively static for the entire year, suddenly soaring?

It turns out, the surge in demand was a paradoxical consequence of an ambitious environmental initiative. In a last-minute attempt to meet annual emission reduction targets, local government officials in scores of cities were reducing the amount of electricity available from the power grid. Officials cut off power supplies, hoping to sharply reduce the amount of pollution spewed by the country's hulking army of coal-fired electricity plants.

But instead of shuttering or reducing production, many Chinese companies fired up diesel-powered generators to keep their factories and businesses running at full capacity. This was the culprit for the sudden jump in diesel demand and a resulting supply shortage. When the amount of grid electricity available was restored, diesel use returned to normal levels.

China is the world's largest energy consumer, the second-biggest economy and the primary driver of the global economic recovery, making it particularly vulnerable to a potential oil price shock. Political upheaval in Libya and the Middle East pushed crude futures to their highest level in 2½ years this week, raising the spectre of a return to the $140 (U.S.) a barrel oil prices seen in 2008. Prices steadied Friday as top exporter Saudi Arabia moved to boost output to make up for any shortages due to Libya's turmoil.

Despite the pullback, few expect oil prices to decline significantly any time soon. And as the 2010 diesel shortage shows, China's world-beating economy is accompanied by an insatiable appetite for energy. An oil price spike could prove an economic turning point for the country, which is already grappling with rising inflation and a runaway real estate market in many of its largest cities.

Over the long term, rising oil prices could present a major issue for the Chinese economy, said Na Liu, a China strategist who is the founder of CNC Asset Management and an adviser on China strategy to Scotia Capital.

"I do think this is going to be a problem for China," Mr. Liu said.

The main drivers of oil demand in China "are highly unlikely to go lower if the economy continues to go higher. This is why oil is really important for the Chinese economy. The oil price spiking higher is either going to translate into slower economic growth in China or higher inflation and that is not desirable at this stage," Mr. Liu said.

Gasoline and diesel prices are set by China's National Development and Reform Commission (NDRC), which raised fuel prices between 4 and 4.5 per cent this month in hopes of trimming demand and insulating Chinese refiners from the rising cost of crude.

"Excessively fast growth in oil consumption is exceeding the tolerance capacity of our country, economically and environmentally," the NDRC said on its website.

While motorists in Beijing are now paying far more than Americans for gasoline (about $4.28 a gallon, according to Reuters), demand is not expected to decline significantly. Fuel demand rose 12 per cent in China last year and Sinopec expects demand growth to average between 5 and 6 per cent over the next five years.

The potential for a petroleum price shock adds yet another troubling variable to the weighty challenges already faced by China's policy makers.

"The Chinese have lots of policy options but they are not necessarily good ones," Gordon Houlden, director of the University of Alberta's China Institute, said in an interview this week.

Coal remains the biggest source of energy production in China, but oil has also become a lifeblood for the country. Petroleum is a key component in everything from China's huge agriculture sector to the booming auto industry to the cheap plastic goods and the high-end electronics churned out by its thousands of factories for the export market.

Despite its own sizable domestic reserves, China has become increasingly dependant on foreign oil.

In December, 2010, China's total oil supply was about nine million barrels a day. Of that, 4.137 million barrels came from domestic sources and 4.869 million from net imports.

Of the nine million barrels a day that China typically consumes, there are three main products that the oil is typically processed into: diesel, gasoline and naphtha.

Diesel fuel for trucks, tractors used in agriculture and generators accounted for about three million barrels a day in December. Diesel demand is expected to pick up again in March as the spring planting season gets under way.

Gasoline for China's rapidly expanding fleet of automobiles accounted for about 1.6 million barrels a day. Petrol demand is only expected to increase as Chinese consumers continue to purchase new vehicles. Auto sales in China jumped 53 per cent in 2009 and 33 per cent in 2010, cementing the country's position as the world's largest auto market. In January, 2011, auto sales increased 16 per cent year over year to 1.53 million units. Total vehicle sales jumped climbed 14 per cent year over year to 1.89 million units. Both numbers are record highs.

A largely overlooked segment of China's oil market is the refinement of petroleum into a product called naphtha which is used to produce ethylene. Ethylene is then used to make plastic and consumer goods. Naphtha accounted for 1.3 million barrels a day of the nine million barrels a day of China's oil supply in December.

In the short term, China appears well positioned to ride out a sudden oil price shock. Its commercial crude oil inventory was up 2.5 per cent at the end of January from the end of December and inventories of refined oil products jumped 11 per cent from a month earlier, according to the state news agency Xinhua.

Diesel stocks climbed 25 per cent and China Petroleum and Chemical Corp. (Sinopec) said in mid-February that its diesel stocks have surged 93 per cent from levels seen late last year when the diesel shortage occurred.

Still, firms like Sinopec, which buy crude at global market prices and refine it for sale as diesel, gasoline and naphtha for the Chinese market, would see profit margins squeezed in the event of a big spike in crude. When oil prices soared to record levels in 2008, China's government moved to subsidize Chinese refiners to preserve profits.

With its deep-pocketed government coffers, China could certainly afford to offer such subsidies again. But as demands and promises for social services, including health care and affordable housing increase, corporate handouts are not as politically viable as they once were. On the other hand, if Sinopec and fellow refiners such as PetroChina see profits plunge, there would be an impact on Chinese and foreign investors and a negative effect on the broader economy.

One thing is certain, a prolonged oil price spike is sure to accelerate China's already significant efforts to develop alternative sources of energy such as wind, solar, nuclear and methanol (which is derived from coal and blended with gasoline).

China won't, however, be able to power its trucks or cars with solar, wind power or uranium any time soon. Producing more methanol would involve burning more coal, which would exacerbate China's dubious position as the world's largest polluter. And when the end of the year approaches, local government officials may again resort to their old trick of crimping electricity from the power grid - sending demand for diesel soaring.

If oil prices are significantly higher than they are now, the decisions made by municipal mandarins out of self-preservation will have significant consequences for both China and the rest of the world.

"We're all in this together," Mr. Houlden said.

"Including China."