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Petroeconomics--the U.S. vs. China

July 20th 2009

Energy / Environment - China Oil

The events of recent months have exposed the differing approaches to energy as practiced by China and the US. China has lent Brazilian oil giant Petrobras US $10 billion to further its offshore exploration work in return for a flow of oil equaling 160,000 b/d. It has lent Russian oil firm Rosneft $15 billion and Russian pipeline operator Transneft $10 billion for agreeing to supply 300,000 b/d from new fields in East Siberia for the next 20 years. In Venezuela, China is to contribute $8 billion to a strategic fund for oil development that aims primarily to increase Venezuelan oil exports to China by 650,000 b/d by 2015.

China is taking the long view, paying money now to ensure growth in the supply of oil and long-term access to its share.

By contrast, the Obama administration announced measures intended to achieve greater payments from oil E&P companies operating in the core area for US oil production — the Gulf of Mexico. The administration has argued that oil companies failed to pay royalties which might otherwise have been expected. While the US government is entitled to sell its societal resources on fair and commercial terms, the net result nevertheless will be to make oil production more expensive in the US. Furthermore, the US government has delayed opening other offshore areas to incremental exploration and possible production.

So while the Chinese are forging ahead to assure access to production around the globe, the US is seeking to reduce or limit its domestic productive capacity. Why the differences in approach?

As a practical matter, each country is driven by its own domestic priorities. US Energy Secretary Steven Chu has acknowledged three objectives for US energy policy: energy affordability, energy security, and environmental protection. But among these, he clearly values climate and energy independence most highly. The Wall Street Journal quotes Chu as saying that he would, "do what I can to encourage stability" in oil prices, but that his time would be better focused, "on the issues that I have control over," such as increasing US funding of alternative energy technologies.

In his appearance at the Summit of the Americas in Trinidad and Tobago, Chu highlighted climate change issues, stating that the prospect of more severe hurricanes and rising sea levels in the Caribbean is "very, very scary." For Secretary Chu — and by extension, for the administration — long-term environmental risks outweigh medium-term oil supply risks. To the extent that energy supply is a concern, the prescription is disengagement from the world economy — energy independence through conservation and domestic renewables — rather than global integration.

Chinese priorities are almost exactly reversed. For the Chinese, growth remains the paramount objective. The need for political legitimacy and the perceived requirements of social stability have led Beijing to believe that the country must maintain an 8 percent growth rate. Achieving this objective will require vast quantities of resources, including oil, coal, copper, iron, and other commodities used in agriculture, energy, and manufacturing. While not insensible to climate issues, China remains a poor country over all, and more basic priorities, for example, the removal of particulates and noxious gases from the air, are yet to be achieved. Carbon emissions reduction remains a luxury well down the list of priorities.

Which government has it right? Secretary Chu may prove correct in his dire predictions of climate change. Nevertheless, recent satellite data does not support his assertions.

Global temperatures have not risen in the last 10 years and have fallen in the last three; sea levels continue to rise at just over 3 mm per year — about a foot a century, as they have since 1992; and global hurricane days continue to languish near 30-year lows. Climate change may represent mankind’s greatest challenge, but the data does not indicate an imminent threat.

The same cannot be said of the oil supply. Since October 2004, according to US government statistics, the global oil supply has not grown materially, despite the enormous price increases that preceded the current recession. Will the oil supply now experience a breakout, surging to new levels? Many in the oil business doubt it. Most of the oil majors are post peak production and are at best struggling to hold output levels. The same is true of countries. Research published by Douglas-Westwood indicates that, while 52 countries were post-peak in 2002, there are now at least 66. In particular, Russian oil production is likely to fall significantly over the next few years — some expect by 500,000 b/d (at the time when China will be increasing its share of Russian output).

So the odds of the oil supply increasing greatly from today’s levels do not appear high. Further, if we take the Energy Information Association’s (EIA) statistics at face value, it is hard to conclude that we are not already on or very close to the peak. Such peaks can last a long time, as long as 15 years. But one plausible scenario would foresee the peak to last no more than seven years; that is, oil production could begin to decline within this administration. Perhaps some unexpected technical breakthrough will increase recoverable oil, or unconventional oil may prove more prolific than recent experience would suggest. But no such "silver bullet" is in evidence today.

Inelastic global oil supply coupled with a recovering global economy could spell very high prices. Indeed, EIA has predicted tightness in the oil supply as soon as 2010. Over the longer term, the stresses may be even greater.

China’s oil consumption per capita should, in principle, evolve in a pattern similar to that of South Korea or Japan. Were China to follow Korea’s path of development — as it largely has to date — by 2030, Chinese consumption could exceed 50 million b/d, two and a half times that of the US today. Could that happen? Consider the example of coal: In the last four years, China’s coal consumption has increased as much as total US consumption. By rights, oil consumption should follow in coal’s footsteps as China develops.

Looking to the future
Macquarie, a leading natural resources investment bank, sees oil supply and demand returning by 2013 to the tightness seen in the first half of 2008. This could imply oil prices re-visiting the $150 level. Can the global economy sustain such high prices? The evidence suggests not. The recessions of 1974, 1980, 1983, and 1991 were all linked to high oil prices.

Recent work by economist James Hamilton suggests that almost the entire current downturn could be attributed to last year’s oil price surge. Of course, other factors mattered, but even a casual observer will recall the chest-constricting feeling that high oil prices inflicted on US consumers to mid-2008, and no one will fail to notice that the economy collapsed just as oil hit $147/bbl. Are we prepared to base policy on the assumption that the global economy can sustain $150/bbl oil?

So by the numbers, the Chinese have it right. We will need all the oil we can get. While protecting the climate is a worthy goal, in reality, oil prices are likely to return to unsustainable levels far before global warming undermines the environment.

Mr. Kopits manages the New York office of Douglas-Westwood, energy business consultants. The opinions expressed are his own, and do not necessarily represent the opinions of Douglas-Westwood.

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