He who has great power should use it lightly.
    — Lucius Annaeus Seneca

Double-digit demand growth in China is a fundamental driver of the oil price. The United States and China are locked into a spiraling mutual dependency in which the People’s Republic manufactures consumer goods and Americans buy them. China’s share of world oil consumption is now about 9% and rising yearly. This summary of the IEA’s World Energy Outlook 2007 describes a scenario in which world oil demand reaches 116 million barrels per day in 2030, with China consuming 14% of the total. Are these projections realistic? The view here is that China is not an exception to the inexorable rules of supply & demand. Current economic growth rates driving oil consumption in the People’s Republic will not be sustained as the Chinese seek to bring their own economic growth under control and maintain a semblance of balance in the world’s markets.

The Pie Chart Problem

No one on the peak oil side of the liquid fuels debate believes the IEA’s estimate that the world will eventually produce 116 million barrels per day (bbl/day). More optimistic voices within the oil industry also doubt the IEA’s forecast. James Mulva, CEO of Conoco Phillips, stated that “I don’t think we are going to see the supply going over 100 million barrels a day and the reason is: Where is all that going to come from?” Even the IEA’s chief economist Fatih Birol has trouble believing his own agency’s forecast, saying—

On the energy security, oil prices part, the numbers, one doesn’t need to be a big energy expert or anything: it’s just mathematics. I can tell you that we, in the next seven to eight years, [the] need to bring about 37.5 million barrels per day of oil into the markets, for two reasons. One, the increase in the demand, about one third of it, and two thirds, there is a decline in the existing fields [and there is a need] to compensate for the decline. What we have done is that we have looked at all the projects in the OPEC countries and the non-OPEC countries, all the producing countries of the world, at the 230 oil projects, on a field by field basis, how much oil they will bring to the markets for the next five to seven years. And these are projects which are financially sanctioned projects. If they all see the light of the day in a timely manner, they will come up about 25 million barrels per day. So, 37.5 million on the one hand, what is needed, and what we expect is 25 million barrels per day, and this is in the case of no slippages, no delays in the projects, and everything goes on time, which is very rare. So, there is a gap of 13.5 million barrels per day.

Oil Consumption Pie Chart The IEA has become a bit schizoid about its own outlook, although you wouldn’t know that if you got all of your information from the New York Times, whose Clifford Krause, writing about the multi-year surge in world commodity prices, duly reports that “the International Energy Agency [IEA] projects that China and India combined may increase their oil consumption to 23.1 million barrels in 2030 from 9.3 million a day in 2005” (Chinese and U.S. Demand Drives Commodities Surge, January 15, 2008).

Fatih Birol indicates that the oil pie is not going to be big enough for everyone to eat their desired portion. The Pie Chart Problem asks how big the entire pie will be in 2015, 2020 or 2030, and within that pie, how big everybody’s slice is going to be in those years. The sample consumption pie (graph left) uses the U.S. Energy Information Administration’s data for the 3rd quarter of 2007 (from this Excel spreadsheet). Mindless extrapolations of China’s current oil demand growth assume that the pie gets larger and larger, and that China’s piece of the pie grows accordingly. The WEO 2007 describes the IEA’s reference scenario for China.

Conventional oil production in China is set to peak at 3.9 mb/d early in the next decade and then start to decline. Consequently, China’s oil imports jump from 3.5 mb/d in 2006 to 13.1 mb/d [million barrels per day] in 2030, while the share of imports in demand rises from 50% to 80%.

A simple calculation reveals that China’s oil production is expected to be 3.275 million barrels per day in 2030. This number is not credible, but let’s assume it for now. The IEA projects that China’s share of the 116 million barrel-per-day pie will be about 14% in 2030 (16.375 million barrels daily). China’s oil demand may indeed be 14% of the global total in 2030, but few believe that global oil flows will be anywhere close to the total in the IEA’s reference scenario.

Let’s examine factors impinging on China’s current oil production and their future consumption growth rate, and their peculiar economic relationship with the United States in order to better understand the prospects for China.

China’s Dilemma

Chinese Oil Production As in the OECD countries, China’s economic growth depends on oil they can not produce themselves. China is at peak production now if the usually conservative IEA’s prediction is correct (graph left). Most of China’s oil production depends on mature fields that have peaked or are in decline. Marketwatch reports that Daqing, China’s largest field, produced only 41.7 million metric tons (834,000 bbl/day) in 2007, down 4% from 2006 and considerably less than the peak output of 50 million tons achieved in 1975 and 2003. Polymer flood enhanced oil recovery (EOR) has failed to maintain production levels at Daqing (Surfactant boosts polymer EOR effectiveness at Daqing, Oil & Gas Journal, June 5, 2006).

Production at Shengli, China’s second largest field, remains stagnant. China View reports that production at the field stood at 27.708 million metric tons (554,160 bbl/day) in 2007, up only 3.4% (18,629 bbl/day) over production there as of January, 2006. Sinopec is using chemical EOR at Shengli in a desparate attempt to maintain the field’s production plateau. China’s oil production is on the ropes. Production from Nanpu Jidong will provide too little help arriving too late to stem annual production declines in China (ASPO-USA, May 16, 2007).

Future production declines will force The People’s Republic to import more oil to meet growing demand, but China is already stressed by the inflation that accompanies an overheating economy. The New York Times reports that “consumer prices were 6.9 percent higher in November than a year earlier — a figure that represented an 11-year high.” Prime Minister Wen Jiabao is loathe to pass higher energy costs engendered by $90-$100 barrel oil through to China’s nouveau riche, so he froze domestic energy prices on January 10th of this year, a move that followed the 10% increase in domestic gasoline and diesel prices implemented in November to appease refiners.

Subsidized oil product prices led to diesel shortages last fall because small independent Chinese refiners (called “teapots”) were unable to pass on higher oil feedstock costs. State-owned refineries, which operate at a loss, were also pinched by higher crude prices. Although the Chinese are now expanding their refining capacity, they have taken a “measured approach” to meeting subsidized internal demand. China set for 400,000-bpd oil refinery output rise (Reuters, January 9, 2008) tells the story —

China’s top oil refineries and major new plants will supply an additional 400,000 barrels per day (bpd) of fuel to the world’s second-biggest consumer this year, more than double last year’s rise, a Reuters survey found…

China has taken a measured approach to expanding its refining sector, pushing its big state oil firms such as Sinopec to build enough new plants to meet fast-growing domestic demand while cautioning against excessive expansion…

To stave off supply crunch, which led to widespread diesel rationing last year, Beijing has waived a 17 percent value added tax on fuel imports through March and halved the import duty to 1 percent, rather than risk increasing already high inflation by raising fuel prices to match nearly $100 crude costs.

Reuters reports that China is “importing near record volumes of diesel” this month, a trend which is set to continue especially in light of the 2008 Olympics extravaganza the Chinese are hosting in Beijing this summer. Real and anticipated fuel shortages have already led to hoarding. Why would China deliberately restrain downstream expansion? It doesn’t make sense to subsidize liquid fuels consumption on the one hand, and cripple your ability to satisfy that demand on the other.

China could change the way they do business by pouring money into their refining sector and elsewhere, but this is where the story takes a strange turn involving their financial entanglement with the United States. China certainly has the money. As Platts reports in Why China Can Withstand $90 a Barrel Oil – And Higher, “the Chinese government is … sitting on top of a whopping $1.43 trillion in foreign exchange reserves as of the end of September.” And where is that money? Approximately 70% of it (a trillion dollars) is in U.S. dollar assets, mostly treasury bonds. In effect, China has been propping up the U.S. economy for the last several years now as described in James Fallows’ The $1.4 Trillion Dollar Question (highly recommended, The Atlantic Monthly, Jan/Feb 2008).

Through the quarter-century in which China has been opening to world trade, Chinese leaders have deliberately held down living standards for their own people and propped them up in the United States. This is the real meaning of the vast trade surplus—$1.4 trillion and counting, going up by about $1 billion per day—that the Chinese government has mostly parked in U.S. Treasury notes. In effect, every person in the (rich) United States has over the past 10 years or so borrowed about $4,000 from someone in the (poor) People’s Republic of China. Like so many imbalances in economics, this one can’t go on indefinitely, and therefore won’t. But the way it ends—suddenly versus gradually, for predictable reasons versus during a panic—will make an enormous difference to the U.S. and Chinese economies over the next few years, to say nothing of bystanders in Europe and elsewhere.

China has an exquisite dilemma. If they allow their economy to expand too rapidly, and pay any price—they can obviously afford it—for additional imported oil or finished products while continuing to support domestic price ceilings, they will help push world oil and gasoline prices so high that they will harm their customers, driving down demand for their exports. As Fallows points out, whenever a Chinese official raises a trial balloon even hinting at the possibility that the Chinese might start unloading dollars and investing them to subsidize rapid growth in their own economy, “phrases like ‘run on the dollar’ and ‘collapse of confidence’ [show] up more and more frequently in financial newsletters.” China has deliberately chosen to inhibit their own growth to keep their export customers, especially the United States, happy.

If Wen Jiabao continues the price freeze to tame inflation, he risks fuel shortages as subsidized demand spirals out of control. Supply insufficiencies force the Chinese to import more oil and refined products, which drives up world crude prices. Higher oil prices mean lower crack spreads for Chinese refiners who already operate at a loss. Shortages have various effects that inhibit economic growth. If the Prime Minister deregulates energy prices, inflation will spiral out of control as higher domestic prices put a crimp in Chinese oil demand and the economic growth that spurs it on. This outcome is politically unacceptable to the Wen Jiabao and the rest of the Communist Party leadership.  One way or the other, economic growth must slow down in China. It already has according to Platts, which reports that oil demand growth was a “sluggish” 3-5% year-over-year in September, 2007.

The Prospects for China

The naive view taken by the IEA and other forecasters is that the rapid growth of the Chinese economy will continue unabated in future years. That’s not the viewpoint taken here, nor does it appear to be the view of the Chinese leadership.

  1. China must balance its economic growth and the health of the global markets for its exports.
  2. The People’s Republic must slow down its growth in any case. China’s internal balancing act requires it to gradually lift price controls and slow inflation.
  3. China’s pending oil production peak, along with the tight world petroleum market, forces it restrain oil imports and promote fuel consumption efficiency. Unconstrained oil demand growth creates a conflict with consideration #1 above.

China’s Information Office of the State Council issued the country’s first ever white paper  on its energy conditions and policies on December 26, 2007. Unsurprisingly, the text emphasized efficiency in China’s energy use now and in the future.

From the longer term perspective of the pie chart problem, China will most likely end up with a fair-sized slice of an oil pie much smaller than that envisioned by the IEA’s World Energy Outlook, at least in medium-term. Surely, the Chinese know that. In the longer term, China will have to live within global oil supply limits just like every other large oil consumer. Hysterical accounts in the Western press imply that China will gobble up all the oil, driving up prices to unholy levels and leaving none for the rest of us. China must operate within the world economy. Otherwise, they will have no one to sell their products to. The unsustainable economic relationship between the United States and China must end at some point. Whether this will lead to the collapse of neither, one or both of these economies is unknown at this point. In all of these cases, Chinese economic growth, and therefore their oil consumption growth, will slow down. That much, at least, seems clear.

Contact the author at the original article.