14 April 2017

** Energy Fact & Opinion: China's Net Oil Import Problem


Crude oil shipments to China from the Americas hit an all-time high in March, with the region’s share of the Chinese market reaching 14 percent. China was the largest foreign purchaser of U.S. crude in February and also made its first-ever U.S. strategic petroleum reserve (SPR) purchase in March. 

U.S., Canadian, and Brazilian oil has made up for a large part of the growth in exports to China, which continue to climb as net oil imports in the largest oil demand growth market in the world continue to grow. 

Driven by the combination of sustained oil demand growth and declining levels of production, Chinese net imports of crude oil grew by a staggering 0.7 million barrels per day (mb/d) in 2016 and are estimated to grow by a further 0.5 mb/d in 2017 and 0.4 mb/d in 2018. 

In 2016, Chinese oil and other liquid fuel production stood at 4.9 mb/d, falling by 0.3 mb/d from output levels in 2015, while demand grew by 0.3 mb/d. This trend of slowing production is expected to continue with a further 0.2 mb/d decline in 2017 and 0.1 mb/d drop in 2018. 
Domestic Chinese oil production has been hit particularly hard by the oil price collapse. Even with government supports, capital expenditure and production levels have been curbed because of the relatively high break-even costs of its maturing fields. 


Opinion:

China now appears to be shadowing a similar trajectory of growth in net oil imports that the United States followed between 1995 and 2005. In 1995, U.S. net imports of petroleum and other liquid fuels stood at approximately 8 mb/d and grew by over 4 mb/d over the next 10 years to exceed 12 mb/d by 2005, before dramatically falling over the course of the following decade to a level below 5 mb/d in 2015. So, what did the United States do to tackle the energy independence challenges it faced, reverse this trend, and improve its energy security footing?


Jay Hakes, former administrator of the Energy Information Administration (EIA), identified seven key policy measures in his book A Declaration of Energy Independence (Wiley, 2015). These policy measures include building a very large strategic petroleum reserve, putting cars that do not rely so heavily on gasoline on the roads, creating tax incentives to bring alternative fuels to the market, ensuring greater use of electricity, implementing energy taxes designed to persuade a change in energy consumption habits, and encouraging energy conservation measures. China is already pursuing many of these measures aimed at limiting consumption and has also been building an SPR, with the intended goal of reaching a total storage capacity of 500 million barrels by 2020. Ironically, half a million barrels of the recent 8 million barrel U.S. SPR sale, mandated by the Cures Act in December 2016, were bought by China.

Although U.S. energy security policy has tended to focus on demand management, the recent success story for U.S. energy independence and in turn energy security is largely due to upstream supply side factors, primarily increased domestic production of tight oil and gas. What distinguishes the U.S. upstream sector from China’s is that industry and mineral rights are privatized, and it is the prospect of financial reward and competition that comes with this model that drove the U.S. shale revolution and has continued to drive down operating costs. China’s upstream sector on the other hand is dominated by its national oil companies (NOCs), and here lies a problem. Its conventional oil and gas sector largely remains off-limits to private capital, and foreign participation is only permitted in production-sharing contracts with the NOCs. While the unconventional oil and gas sector has been opened to private-sector involvement, foreign participation is still limited to joint ventures with Chinese firms. As such, operating costs for domestic Chinese production has remained relatively high in comparison to the United States, which in part is due to the limited levels of private capital and competition permitted in the market.

While China is taking steps toward encouraging greater levels of investment and competition in the exploration and production sector, the Five-Year Energy plan released by the Chinese National Development and Reform Commission (NDRC) in January of this year set oil production for 2020 at approximately the same levels reached in 2016. At the same time, they estimate that demand for oil will grow by 8 percent from current levels. These forecasts appear to be on the conservative side in terms of estimated growth of reliance on imports, with International Energy Agency (IEA) data suggesting that oil import dependence will reach 69 percent by 2020. The message that net oil imports will continue to grow is clearly recognized by the Chinese government, but with this increasing reliance and vulnerability, what solution if any does the government have?

China’s response so far to sustained growth in net oil imports has been to focus its energy security policy on ensuring security of supply, which in part helps to explain several facets of Chinese foreign policy. For example, China has been diversifying its imports with its NOCs and national banks by extending oil-for-loan deals with the likes of Angola, Venezuela, Brazil, Russia, and Kazakhstan. China’s race to ensure security of supply can also in part explain the development of the One Belt, One Road (OBOR) initiative and the various pipeline deals that have been brokered with the likes of Russia, Kazakhstan, and Myanmar. Chinese NOCs have also been acquiring production assets abroad and have entered various production-sharing contracts overseas.

Chinese NOC investments in producing states may however be exacerbating the net oil import problem, as large amounts of capital expenditure are being directed abroad and more recently toward downstream assets, while much of the domestic industry remains off-limits to private and foreign capital. In the current price environment, the outlook for domestic Chinese production growth remains bleak, and so for the moment, the government appears to have no solution for the growing energy independence challenge it faces, with no immediate apparent ability to increase domestic production or significantly reduce growth in demand. Thus, the Chinese oil supply deficit will continue to grow, and stable exporters like Brazil, Canada, and the United States are likely contenders to help fill that gap.

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