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Even a cursory glance across the vast array of forecasts, outlooks, and annual reviews that fill the news at the start of every new year reveals how much China looms large in the energy world. While the Western world remained mired in recession, China boomed and this single country market is increasingly seen not only as the leader of Asia-Pacific energy trends, but the future global epicenter for energy demand.
In early 2011, the China Petroleum and Chemical Industry Federation projected crude oil consumption would rise 6% in 2011, a dizzying pace of growth in a global economy only now recovering from the crash of 2008. Yet the group predicted that natural gas consumption would rise this year by 15%.
Already Asia Pacific’s largest refiner and oil consumer and the world’s largest coal user, China seems poised to shape not only regional oil, gas, and coal sectors, but also energy worldwide. And since Beijing increasingly draws on imported oil, gas, and now coal, according to the government’s National Energy Administration (NEA), this market will top 2010’s coal imports of 146 million metric tons per annum (MM MTA)—Beijing’s long run of sustained economic growth has not only made it the arbiter of regional energy patterns, but a major shaper of energy trends worldwide. China will ramp up conventional fuel imports and production to continue to power economic growth, despite trumpeted efforts to develop clean, renewable, and alternative energy.
The basic energy statistics reported remain astonishing. The NEA predicted for 2011:
Accelerated development of 14 separate coal mining centers will provide sufficient supply to keep up with national demand. Coal accounted in 2010 for a higher percentage of base energy supply in this market than any other major economy, making up 70% of the country’s base energy use and 80% of power generation fuel.
This coal, in large part, will underpin forecast power demand growth of “only” 9% in 2011, with power demand reaching a total of 4.5 trillion kilowatt-hours (KwH) after a 2010 rise of 14.6%.
Apparent oil demand would rise 12.3% to 449 MM MTA, or 8.98 million barrels per day (b/d). Crude imports would continue to grow despite 2010’s unusually large gain of 6.9%. In 2010, the NEA said crude imports rose 12.5% to 239.3 MM MTA, or nearly 4.79 million b/d, and domestic oil output increased to 203 MM MTA, or 4.06 million b/d. Even greater gains were seen in gas. The NEA forecast a 20.4% jump in demand to 130 billion cubic meters (BN CM), or 12.57 billion cubic feet per day (BN CFD), outpacing a 16% rise in domestic gas production that will reach nearly 110 BN CM (10.64 BN CFD)—a gap of over 1.93 BN CFD. To help fill that gap between expected gas use and anticipated gas output, piped gas volumes from Central Asia will have to rise substantially above the 4.4 billion cubic meters, or 425 million cubic feet per day (MM CFD), recorded in 2010 and LNG purchases will have to be boosted sharply from 2010 import levels of nearly 13 BN CM (967 MM CFD). China National Petroleum Corp. (CNPC) is expected to quadruple piped gas imports by end-2011 to reach 17.7 BN CM (1.714 BN CFD). The government predicted gas would make up 8% of national primary energy use by 2015, nearly double 2009’s level.
The impressive numbers continue for non-hydrocarbon energy. Beijing has 20 gigawatts (Gw) of hydroelectric capacity under construction—nearly one-tenth of its already-operating 210 Gw. Already the world’s largest producer of wind power at 41.8 Gw capacity, the government plans to add a further 14 Gw, while connecting much of current isolated power generation to the national power grid. Solar power capacity continues to grow at an astonishing pace, with 300 megawatts (Mw) planned for completion in 2011 after 400 Mw were completed last year, raising total capacity to 700 Mw. Conventional non-hydrocarbons have not been neglected either, as China has 28 nuclear reactors under construction totaling 30.97 Gw, despite misgivings after Japan’s tsunami disaster.
How can we interpret the numbers and what do they augur for the future? This paper will focus on China’s current and future place in the regional and global energy sector and argues that much of the outside world’s view of Chinese energy is distorted by fundamental misconceptions that reflect the view of traditional Chinese oil and gas use.
Statistics—or rather the lack of timely, accurate, public, comprehensive, coherent statistics—are the bane of the China energy analyst. Unlike almost all major oil markets around the globe, China lacks official demand and sales statistics on a national, provincial, municipal, or sectoral level; the government releases no official crude, oil products, or gas stock figures. Basic oil and gas statistics such as import/export trade, refinery output, and crude and gas production by field are given, at best, on a monthly basis—nothing like the weekly summary provided to oil markets in the United States by the American Petroleum Institute.
Most analysts agree that customs data, consisting of major oil products and crude, has been consistently the most accurate statistics offered by the Chinese government over the past decade, but even there problems exist. Bunker sales—considered in some countries exports and in others domestic demand—have never been included in import/export data, and APEC estimated that in 2010 fuel oil sales for ships’ fuel approached 200,000 b/d.
The complete absence of national demand and stock data on a timely basis has been noted. Analysts fall back on the annual China Statistical Handbook to check their calculations, and this is released 18 months after the year covered. Yet for statistics available and issued regularly, we see refinery production and company sales as the areas most in need of reform. While the two biggest downstream state firms—China National Petroleum Corp. and China Petroleum and Chemical Corp. (Sinopec)—do release such data, they unwittingly have distorted perceptions for product supply. As of January 2011, APEC surveyed 13.4 million b/d in Chinese base capacity. Yet the third largest national refiner, China National Offshore Oil Corp. (CNOOC), does not release any refinery production data, despite operating 1.1 million b/d, nor do China’s small, independent refiners, which operated roughly 1.7 million b/d in distillation, with about three-quarters of that focused in the northeast province of Shandong. No official data on refinery output ever has been released on a regular basis from either of these two groups and of course mini- and micro-refineries, often operating semi-legally, have their output unrecorded.
A further difficulty with Chinese statistics has been the failure of the government and companies to adopt fully international energy data norms, despite pledges to the International Energy Agency (IEA) and other multilateral organizations to standardize energy statistics to international industry practice. A good example is the term “petrochemical feedstock,” used in government statistics as well as CNPC/Petrochina and Sinopec data. Some analysts take this to mean “naphtha,” specifically paraffinic naphtha used to produce olefins (mainly plastics). Yet while paraffinic naphtha made up most feedstock use over the past decade, petrochemical feedstock includes feedstock used both for olefins and aromatic petrochemicals and also has been comprised of gas oil, direct use condensate, limited LPG, and experimentally, ethane.
Refining terminology is a minefield for the unwary. Hydrofining is often used for cracking (mild or severe), while sometimes it is meant as hydrotreating, or even hydrodesulfurization. Vacuum distillation unit (VDU) capacity has never been stated for most Chinese refineries, and this is an important indicator of how easily a refinery’s distillation tower can process heavy crudes. No professional association lists official design capacity for refinery units, nor does the government track such basic data.
But the problems in statistics are not solely of poor quality or fragmentary data, but also spring from the misperceptions and misconceptions of many Western analysts often unfamiliar with the Chinese market in any practical way. With limited commercial experience, they make fundamental misjudgments. When they read that China is moving to European Union (EU) product specifications (known as Eurospecs), for example, they assume that future Chinese product quality will fully comply with EU standards. China, though, has never followed Eurospec quality standards point-by-point. Further, many analysts fall into the mental trap of many energy economists assuming that because Western oil and gas markets evolved in a certain fashion, Beijing is compelled to follow that development path in lockstep fashion. This has been shown to be completely false in the past, and we believe China’s differences from the West will continue to be demonstrated in the future.
When the reader reviews numbers in an analysis of Chinese oil or gas, the guiding rule is caveat emptor—let the buyer beware. What is presented as “demand” is often apparent demand; what is said to be “gas production” is often only wellhead output, not usable gas.
One of the more interesting events that unfolded over the recent recession was the reaction of governments worldwide to attempt to revive flagging demand in face of the fear that swept markets after the collapse of Lehman Brothers in October 2008.
China, like most major economies, moved to quickly implement a stimulus program to jumpstart demand and stem market panic. Beijing implemented its first stimulus package of $568 billion in November 2008. It quickly followed up with a second stimulus round, focusing on refinery and petrochemical investment, that totaled more than $800 billion and was implemented in February 2009, and concluded with a final $440 billion, concentrating on renewable energy, by September 2009.
The vast bulk of this funding went to completing refinery and petrochemical capacity that was already approved by the central government and often had construction under way. Completion of a number of oil and gas pipelines was similarly given top priority in stimulus funding. Almost all direct funding was targeted at jump-starting stalled capital projects in the domestic market. Funding for state companies buying upstream assets abroad never faltered despite the end-2008 downturn, but was accounted separately from, though parallel to, stimulus funding. Of the roughly $2 trillion offered in stimulus funding, we estimate that about 60% was earmarked for refining, petrochemicals, and pipelines; of that, $800-$900 billion was used in refining, petrochemicals, and pipelines, while the remaining $300-$400 billion went to renewable energy, mainly wind and solar power.
In contrast to many Organisation for Economic Co-operation and Development (OECD) economies, Beijing’s stimulus efforts had a clear and near-immediate impact in spurring domestic economic growth. Oil demand began to revive by early 2009. Why, then, the great difference? The answer is simple: China is in transition from a planned command economy to a free market. It has a far higher share of state investment, and a far lower proportion of private consumption, than the typical OECD economy.
A simple macroeconomic comparison between the economies of China and the United States answers why the two were impacted differently by the Great Recession. Consumer demand (i.e., private consumption) in China at its peak was 25% in 2008, compared to roughly 70% in the United States. Fixed asset formation in China was roughly 70%, with two-thirds of that coming from government investment, compared to roughly 22% in the United States. Exports accounted for about 5% of the Chinese economy and less than 3% of the U.S. economy. Capital formation is easy to stimulate—the Chinese government poured vast funds into projects—but consumer spending is harder to prompt. Stimulus worked in China in part because of the nature of the Chinese GDP; the failure to stimulate private consumption was part of the reason the U.S. recovery was, at best, tepid.
But the impact of these stimulus programs was broader and longer term than simply getting the overall economy pumping again. In oil, gas, and petrochemicals, billions of dollars in inexpensive loans and outright grants were made to the first-tier state companies, CNPC (with its operating arm Petrochina), Sinopec, and CNOOC, as well as smaller sums to national, provincial, and municipal oil/gas companies. The net result was to spur a sustained expansion of refining and petrochemical capacity rarely seen outside of a national emergency, such as a war, and to allow Chinese companies to continue their buying spree for overseas (mainly) upstream assets, when most private and state oil companies curbed spending in the face of the economic downturn.
Some of the longer term impacts of the Great Recession began to emerge by mid-2011. First is that stimulus perhaps worked too well, and that inflation had begun to loom by end-2010 as the biggest domestic macroeconomic problem. The Chinese government and central bank since then have been doing their best to cool down what has been seen as an overheated economy. Lower growth rates, at a more sustainable pace, were the new grand economic target.
The impact of the stimulus has been enormous, with a large number of refining, petrochemical, and energy infrastructure (pipelines, port renovation, storage) completed and substantial capacity yet to be commissioned. From January 2010 to January 2011, Chinese base refining capacity expanded by 1.6 million b/d and topped 13.5 million b/d and by 2014, based solely on projects that have already begun, this market will add a further 2.0-2.5 million b/d. China’s distillation capacity is roughly twice as large as that of Japan and South Korea combined and more than two-thirds the base capacity operating in the United States. The buildup in petrochemical capacity has been even more breathtaking. In the years 2009-2010, Chinese ethylene cracking capacity (olefins sector only) rose from 13.1 MM MTA to 15.5 MM MTA and should expand further to 19.5 MM MTA by 2014.
Looming overcapacity may impact either refining or petrochemicals, though we believe that a supply overhang will be far more likely in refining. Price controls and retail subsidies impact oil demand far more directly than petrochemical consumption (see section below). A strong case can be made—based on petrochemical use per person, petrochemical demand based on GDP, and petrochemical product use in some of the fastest growing sectors, such as vehicle manufacturing and processed food packaging—that still-to-be-commissioned olefin capacity will be utilized. It is unclear whether incremental refining capacity will run at a high utilization rate by mid-decade. Oil imports are a source of growing concern for central planners. For the first time in recent months, China exceeded the United States in its proportion of imports to total crude oil use.
There was substantial speculation in 2009-2010 that China would be the engine that pulled the world economy out of recession. These hopes have been dashed as China’s domestic market—i.e., its portion of GDP that is based on private consumption—still was not large enough to alone pull China out of recession, let alone the global economy. Yet China’s newfound economic importance has been underlined by its support of Asian economic growth. As the possibility of a double-dip recession loomed in mid-2011, it appeared that Chinese economic growth, albeit at a lower rate, would continue to support overall Asian growth. Yet China remained at base an export-oriented economy, as the 2008-2010 recession revealed. Once all export niches were filled, growth in China necessarily slowed.
Yet it is the issue of oil, gas, coal, and power subsidies that perhaps most shapes Chinese energy use. The topic is vast and complex in China—a function of its transition to a market economy—and we can say in summary that while many subsidies have been rolled back or abolished, many others still continue and cause what energy economists characterize as the “structural deformation” of the Chinese economy. Decades of energy subsidies have created an economy based on high-energy intensity—i.e., the amount of energy needed to create additional GDP—and a major aim of government planners is to reduce this by 2020.
Oil prices in China were traditionally kept below average Asian levels, let alone world levels. Some products were only in part price controlled, allowing market pricing in certain sectors. LPG produced from onshore gas fields or refineries has remained price controlled, but imported LPG or LPG produced from offshore gas field could be sold at free market price. Yet overall prices were kept low, encouraging unnaturally high demand growth. This, as much as true general economic expansion, has been the primary driver in ballooning Chinese oil consumption.
But since the recession gathered pace, there have been signs of a reversal. From mid-2009 until late 2010, the consumer, on average, paid more for Chinese gasoline than that produced in the United States. Of course, despite the pretense that gasoline prices are set solely by a free market, U.S. transport fuels, too, have wasteful biofuel subsidies and a tax tariff policy that favors gasoline over road diesel use.
The Chinese government’s current pricing system is basically a ceiling/floor mechanism linked to world prices through the Singapore spot market. However, the current mechanisms are too slow to respond to changing prices and often do not fully reflect the impact of price changes. Beijing is well aware of that—but as the government rides the tiger of subsidized oil demand growth, it prefers to try to reform the current system and avoid the twin dangers of popular unrest and stoking inflation, two likely impacts of a decisive break with the ceiling/floor pricing system. It should be noted that price distortion is a double-edged sword—price controls have kept China out of sync with both higher and lower world oil prices.
The great gas oil squeeze of late 2010 illustrated the problems China has in moving toward a market economy while still setting macro-economic goals in Five-Year Plans. In October 2010, a number of provincial governments, under enormous pressure from Beijing to meet the national goal of cutting energy intensity by 20% in the 2005-2010 Five Year Plan, began limiting power consumption. This forced many businesses to shift to gas oil-based mobile power generation. The impact was particularly noticeable in provinces such as Zhejiang and Guangdong, where manufacturing activity had already begun to rise sharply by mid-2010. Across the Southern and Eastern Seaboards, old generators were recommissioned and new units purchased. This was the primary cause of a startling run on gas oil supply.
The large-scale refinery expansions of 2008-2010 were expected to create a gas oil supply overhang; instead, the central government created a near state of emergency and authorized all refineries—even illegal plants—to run at maximum capacity in order to plug the gap. By late October 2010, Chinese refineries were producing an incremental 170,000 b/d of gas oil/road diesel—roughly equivalent to 5% of national demand that month.
There were, of course, secondary reasons for the sudden gas oil shortage, including delays in large infrastructure projects that year and booming export sales due to a shortage in European gas oil supply. But the gas oil affair illustrated what a tricky balance the central government must attempt in its transition to a market economy as well as how dangerous the current subsidy system remains for national oil supply.
It appeared in most recent government declarations that policymakers will back into free market prices through the issue of energy efficiency, with the unfortunate gas oil snafu of 2010 illustrating how not to proceed. The National Development and Reform Commission (NDRC) has issued regulations that will, over a period of time, close down inefficient petrochemical, refining, and other heavy industries that use excessive oil and gas. We expect that China’s domestic oil product prices will gradually move to parallel world levels, just as over the past three years national gas prices have moved ever closer in step with world prices. The concept of closing down inefficient power generation was correct—it was the haphazard implementation to meet the deadline of a Five Year Plan, Beijing has concluded, that caused this supply shortage.
While improving energy efficiency remains the goal, and moving to an alternative pricing system the means, by mid-2011, despite more than two years of discussions, China has been unable to improve its pricing system to better reflect energy costs and curb wasteful and inefficient consumption of oil and gas. A key concern behind this sustained hesitation to reform has been worries about inflation, with the government concerned that a more market-based pricing system would raise inflation rates, which peaked at a three-year high in June 2011. The government realizes that the current system cannot last much longer; yet its faith in the ability of markets to regulate prices remains minimal—and the NDRC, which sets policy and prices, often delays price increases for fear of stoking inflationary pressure for an overheated domestic economy.
Still, the NDRC has begun a limited experiment to make the current pricing system more reflective of and responsive to world prices. In August 2011, the NDRC began setting Jet A-1 (aviation fuel) prices monthly, with levels linked to the Singapore spot market—“a big step toward a market-oriented system,” according to the Chinese government bureau, and a precursor to reform of the other two transport fuels, gasoline and road diesel. Jet prices will be based on ex-refinery gate values and linked to Singapore spot quotes for the previous month. If successful, and if extended to other transport fuels, these measures could have significant impact on East of Suez spot markets—particularly in gasoline and road diesel, where Chinese consumption of a single product often has been greater than the total oil demand of many Asian markets. If China’s product prices move closer in sync with world price levels, this too would reduce direct and indirect oil product subsidies.
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