August 15, 2005
More to the story on Chinese oil demand
As more facts come out about Chinese oil demand, the more fascinating the picture becomes.
I earlier admitted to being puzzled by the conflicting statistics and forecasts coming out of China. Chief among the questions here are: (1) how could Chinese oil demand have grown 17% in 2004 despite a 35% increase in the price of crude oil; (2) how could this demand growth suddenly be reduced to a 1.4% growth rate in the first half of 2005 despite real output growth continuing at 9.5%; and (3) what do these trends imply is going to happen to Chinese oil demand over the next year?
The Oil Drum notes this account from Petroleum World that connects the dots in a way that makes a great deal of sense:
The picture that emerges from careful reading of the IEA reports over many months is of a country that is heavily subsidizing huge growth in demand for oil to feed the insatiable Chinese economy -- and this has led the IEA to some surprising figures in the August report.
The IEA estimates that at the beginning of July suppliers to the Chinese domestic market were losing 20 dollars per barrel or more on every barrel of gasoil supplied.
One finds the following explanation of China's pricing system from the People's Daily Online:
Based on the weighted average price of oil product in the three markets in Singapore, Rotterdam and New York, the wholesale and retail price of China's oil products are determined and published by the State Development and Reform Commission according to the domestic market.
Whatever that means, it doesn't sound like supply equals demand, and the remarkable photo at the right (hat tip: the Oil Drum) doesn't much look like supply equals demand. The picture shows taxi drivers queued up to try to get gas in Guangzhou, the capital of South China's Guangdong Province. The official story is that these shortages were the result of typhoons disrupting oil tanker deliveries, but it is surely symptomatic of some much more fundamental problems with the pricing mechanism in China.
None of this sounds to me like an economy that is capable of sustaining 10% growth in real output. Either users will be forced to pay the real cost of fuel, or economic growth will come to a grinding halt. Either way, this does not look like a country whose petroleum demand can continue to grow at anything like the rates that we have seen over the last two years.
Posted by James Hamilton at August 15, 2005 05:44 PMdigg this | reddit
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I think we read different things into the stories. I read that they have significant shortages, some of which are due to a limit on refining capacity. As more refineries come on line to meet demand from new car owners, they will increase imports. Some of the things they are doing to increase fuel supplies (such as in the coal industry) make me blanch. But signify that with rationing in place, they still do not have enough supply to meet their existing demand. But it is really hard to tell the truth.
Posted by: The Oil Drum (heading out) at August 15, 2005 09:51 PM
Yes, HO, you and I often see the same facts in a different way. When you see that queue of taxis, you think there's not enough gas. When I see that queue of taxis, I think the price is set at the wrong level. But we both see the same queue and we're both struck that, wow, something's really going on here.
Posted by: JDH at August 15, 2005 10:25 PM
You would have to expect that the Chinese government, with their banks chock full of US$s, will find a way to keep the economy steaming ahead (ie State subsidies) until at least the 2008 Olympic games. For them this event's symbolism is that it will be the stage on which to announce to the world their coming of age as a major world power- and maybe the peak of peak oil?
Posted by: Davidw at August 15, 2005 11:39 PM
I'm afraid I'm with Oil Drum on substance here James. Clearly there are to say the least 'peculiarities' in what is happening in China. In the first place it is not a market economy, and attempts to control prices do tend to lead to the sort of anomalies you see in the photo. But to go from this - the obvious - to not being able to understand why in China prices could rise 35% and demand rise 17% surprises me. I think the thing which was worrying me all along was your 'to the letter' reading of the use of the term 'demand' in the Hirsch report. There is obviously a large secular rise in the demand for oil underway.This means a substantial shift in the demand curve over time. As living standards in China (and elsewhere, oh don't forget the elsewhere) rise, a larger percentage of per capita income can be spent on energy, especially if SUVs become a status symbol, and people (maybe this is more likely in China than other parts of the developing world) decide to emulate the US energy-intensive lifestyle. Something similar is happening with housing in the US right now, prices reach record highs, and the number of new starts goes up and up. Demographics play a part, you need to look at the rate of new home formation, things like that. Ditto with China, India, Indonesia, Brazil and car ownership. So large hikes in prices are perfectly consistent with substantial increases in demand in some areas which start from a low base. Of course if supply has a ceiling this will be "fuelled" by a reduction in consumption in other areas, there is no other way.The US consumer seems remarkably sensitive to changes on the margin in gasoline prices, so this is something to watch. And I really think the following is way off beam: - - "None of this sounds to me like an economy that is capable of sustaining 10% growth in real output. Either users will be forced to pay the real cost of fuel, or economic growth will come to a grinding halt. Either way, this does not look like a country whose petroleum demand can continue to grow at anything like the rates that we have seen over the last two years." - -
I mean the get-out clause would be that China isn't growing at 10%, but still. China is (for sound demographic reasons) well able to sustain serious growth (give or take the vagiaries of the business cycle) for the next decade, and maybe the next couple of decades, and demand for petroleum and petroleum products will continue to rise at a healthy clip until and unless some viable substitutes appear on the scene. Of course steadily rising prices should help accelerate that process, and in this sense rising prices could be given a cautious welcome.
Posted by: Edward Hugh at August 16, 2005 12:07 AM
I've certainly heard the argument that much of Chinese demand growth was one off: building storage facilities and petrol stations, and filling them.
It doesn't seem feasible that they can keep subsidising the price of petrol (anyone know what the price per litre of petrol is in China?) indefinitely.
Posted by: John at August 16, 2005 01:27 AM
My pet theory on this is that China has just gone through a phase of extensive growth (think: blast furnaces of Magnitogorsk), and is transitioning to intensive growth (think: semiconductors) - hence their oil-intensity of GDP is falling fast. It's the speed and magnitude of Chinese economic development that has rendered this structural change much faster than any seen before.
Posted by: Alex at August 16, 2005 02:34 AM
We have a similar situation here in Mexico. The government sets the retail price of gasoline (and electricity,and water,and domestic airline prices,and a host of other things). Pemex can't help make money in production, but the state-owned electric company receives massive subsidies from the treasury as do others.
We pay gasoline prices much lower than the US and they haven't moved since crude prices took off. Obviously we're being subsidized. With Mexican oil production starting to decline it will be interesting to see what happens when they can't pay the subsidies anymore.
For that matter,it would be interesting to see how many people around the world benefit from the types of subsidies in China,Mexico and other places.
Posted by: Jim Miller at August 16, 2005 04:57 AM
"My pet theory on this is that China has just gone through a phase of extensive growth (think: blast furnaces of Magnitogorsk), and is transitioning to intensive growth (think: semiconductors) - hence their oil-intensity of GDP is falling fast."
You may be partly right. There is still a hell of a big gap between the coastal fringe and the interior, so while intensive growth may be underway in the relatively developed parts extensive growth is only begining in others.
"oil-intensity of GDP is falling fast"
This may not be the relevant metric. In terms of global oil prices it would be consumption per capita you need to watch, and please don't forget about India, which I think is also subsidising at present.
Posted by: Edward Hugh at August 16, 2005 06:12 AM
Could it be that at least some of the stories/theories about China (and India) are self-serving and designed to promote investments from which the promoters seek to earn a profit?
Here's the real question: Who, if anybody, is in a position to actually validate the "stories" that are being promoted? If nobody, then why not simply file them away as "interesting, but" until the day comes when they *can* be validated?
Why not just count the tankers entering Chinese harbors and leave it at that?
-- Jack Krupansky
Posted by: Jack Krupansky at August 16, 2005 07:57 AM
Another puzzling aspect is that China continues exporting crude oil to the US (Source: http://www.indexmundi.com/en/commodities/oil_gas/us_imports_by_country_200412.htm). I thought that China did not have enough oil to meet its domestic demand.
Posted by: Mike Baker at August 16, 2005 08:28 AM
Mike writes: "Another puzzling aspect is that China continues exporting crude oil to the US
Indonesia is having similar problems"
Don't forget that a lot of oil is traded under long-term contracts. So if China signed a 5 year contract 2 year ago to supply oil at $35/b they have to supply the contracted amount even if oil is now $65.
Indonesia has a similar problem (see http://www.energybulletin.net/7912.html) when they had to start importing oil. They may very well be selling oil at $35 and buying at $65. This of course is playing havoc with their budget for oil subsidies which is now 450% over budget!
Most developing economies subsidize oil and gasoline leading to the mispricing JDH mentions. Since oil is too cheap they invariably end up having to physically ration deliveries in one form or another. The longer the mispricing is allowed to persist the more painful it is to adjust as eventually they must.
Posted by: RayJ at August 16, 2005 08:56 AM
I also think India has to be subsidizing gasoline prices. I was there last fall and come to think of gas seemed cheaper than the world price.
Posted by: Jonathan Bernstein at August 16, 2005 09:35 AM
This is something I've wondered about since a lot of the recent rise in world-wide demand for oil has been attributed to China. In poorer countries, how much would paying market prices affect demand in India, China, Nigeria, et al. and how much would that lessen overall world wide demand?
Also, excuse my ignorance but does this at all tie in to China's buying of US treasuries? I don't understand how that works. But it would seem that since oil is commonly sold in dollar amounts + that China has all sorta of dollars on it's hands from those treasuries that there could be a connection.
Posted by: Allen at August 16, 2005 10:02 AM
"Don't forget that a lot of oil is traded under long-term contracts. So if China signed a 5 year contract 2 year ago to supply oil at $35/b they have to supply the contracted amount even if oil is now $65. "
Reminds me of what happen to Asia crisis 1998, when signifcant amount debt of asian companies were due, and some investors took this opportunity. Which is one of the reason in devaluation of their money value. Does these scenario have a possibility of happening to what happen in the current oil price?...anybody?
Posted by: Jack at August 16, 2005 10:16 AM
I'm curious about the stability of oil markets under present circumstances (ie being so tight). Eg if President Putin decided to withold half of Russia's 9mpbd oil supply from the market, would he get more, after the resulting price increases, for the remaining 4.5mbpd than for selling the whole 9mbpd as at present, given that no-one else has any spare capacity to make up the difference? Is there any way to tell?
Posted by: Stuart Staniford at August 16, 2005 10:32 AM
Stuart, the answer depends on the size of Russia's share of global production relative to the elasticity of demand. The elasticity of demand (e) is defined as the absolute value of the percent change in quantity demanded divided by the percent change in price. If a given country produces a fraction (k) of total output, one can show that the percent change in revenue resulting from a 1% decrease in its production is given by (k/e) - 1, assuming (as you do) that there is zero additional supply from other countries to make up the slack. When this expression is negative, it means the country loses revenue by cutting back on production. Thus, even for a country that controls k = 10% of total world production, the elasticity e would have to be below 10% in order for cutting production to boost revenues. I don't believe that the elasticity is that low.
For example, if the elasticity of demand is e = 0.2, that means that if Russia cut back half its production, call it (for simple math) a 5% reduction in global supply, then the price of oil would rise 25% [(d ln Q / d ln P) = (-0.05)/(0.25) = -0.20]. That gain of 25% in revenue per barrel on the oil Russia continues to sell wouldn't make up for the loss of 50% of its revenue from the oil it's no longer selling.
Posted by: JDH at August 16, 2005 11:28 AM
JDH and Stuart,
This question gets at the fundamental reason for the creation of OPEC. One lesson there was that although it may not be profitable for one country to hold oil off the market, in certain circumstances, it could benefit a group of them.
However, even for OPEC it was not easy to do. Cheating has always been rife as the gain was greater to freeriders than those who actually cut back. In the case of Russia that Stuart brings up, they might not gain, but others who kept pumping the same volume would. None of this, however, takes into account the global economy. Another lesson from OPEC is that prices can only get so high before the golden goose is killed
Another interesting question would be the result of a country (or group) holding oil off the market for political reasons. Iran in particular could respond to any sanctions by "santioning back". Oddly China might be the first victim. This is a complex scenario, but one thing is certain, we would be glad to have the strategic reserve.
Posted by: Jack at August 16, 2005 12:21 PM
Allen, I like your question about how Chinese subsidies might affect Chinese demand for oil. I'm going to opine that in the long run, it will be the same as the subsidies must be paid for somehow and that will be money taken out of the economy. but short term consumers will keep buying gas and goods will remain cheap.
Posted by: eric at August 16, 2005 12:55 PM
The elasticity seems to be a very uncertain number, however. It's not akin to a physically measurable quantity with a somewhat well known value, but rather sums up a bunch of cultural/psychological/economic factors that are pretty variable from decade to decade. Prices have doubled over the last couple of years just because of the lack of a supply cushion. There's been essentially no observable impact on demand due to the increased price until, perhaps, the last few months in developing countries. In 1980, prices doubled because the Iranians removed a few mbpd from the market. So can we be confident that if Russia removed 4.5mpd from the market overnight it wouldn't require a doubling to bring demand back into line (ie meaning no loss of revenue to them)? Are there references studying the elasticity?
(Not to pick on Russia - just an illustrative example as they and the Saudis are the two roughly equal biggest suppliers at present).
Posted by: Stuart Staniford at August 16, 2005 01:58 PM
I agree, Stuart, I'm not sure exactly what that elasticity is. One thing I do know is that it's a bigger number the more time you give consumers to adjust to the price increase. Even if the immediate elasticity was less than 0.1 so that there was an immediate boost to revenue, over time the demand adjustments would erode it away and Russia (or whoever) would be left with less money as a result of cutting back production.
Posted by: JDH at August 16, 2005 02:34 PM
"However, once the price reaches its lowest level in figure 2, producers of the resource will realize that the resource is a lot more scarce then they had previously thought. They will suddenly understand that the price will start increasing and they will cut production in order to maximize intertemporal profit via the Hotelling principle. This cut in production will cause the price shock to be much more sever. In addition, Reynolds (1997) shows that the backstop price of a resource can unexpectedly rise due to the loss of entropy subsidies. It is conceivable that after one hundred years of price decline and production increase, that a resource can have a ten or one hundred fold price increase within a year or two, with a corresponding decline in production. Given that short run elasticities of demand and substitution are much more inelastic, then long run elasticities, this can create quite a problem for an economy to say the least."
Posted by: Max at August 16, 2005 03:06 PM
If so, then we should see immediate price rise, but a steeply declining futures market. Unfortunately, it looks pretty flat.
Posted by: TCO at August 17, 2005 06:28 AM
For first sentence above, add in "with a supply disruption or a demand step change"
Posted by: TCO at August 17, 2005 06:29 AM
Stuart and JDH: regarding Russia taking oil off the market, another thing to consider for their (or any sizeable country) to take the oil off the market to increase the price, is that while total revenue might not be recouped, there is the possibility that total profit could double, while increasing the time of greater profit. In the dot com days people favored revenue over profit, but that was corrected (or at least somewhat corrected). Personally, I'd go for more profit over more revenue, especially with something like oil where brand names/loyalty don't enter into the picture.
Which gets to the question that I seem to remember JDH asking on The Oil Drum why any rational person/entity would continue to produce a lot at a time of coming scarcity. My best guess is the qualifier of "rational" removes the question from reality. Or alternately it's because the entities are composed of many individuals acting in somewhat rational ways, but rational to their personal interests, which might not be aligned with their employing entities rational interests. Just think of Enron.
Posted by: coffee17 at August 17, 2005 07:43 AM
A Strange Phenomenon in Rocketing Oil Price?
Skyrocketing oil prices not only impose potential risk on the global economy, but also making an interesting economic phenomenon in China. While Guangdong province is faced with serious shortage of gasoline for auto as well as industrial uses, oil exports from China to overseas are increasing dramatically. The heading of Ming Pao (a HK newspaper) described it as a strange phenomenon. However, everybody who has studied economics knows that it's absolutely logical in economic sense.
Shortage means quantity demanded is larger than quantity supplied at the prevailing price level (BS! Sorry.) And the reason for shortage is price control (BS again!) We saw severe shortage problems in the U.S. due to price control during Nixon administration. Since the retail gasoline prices are controlled by government in China, current soaring crude oil prices make oil suppliers (explorator, refinery factories and retailers) provide less oil. It is simply because they can earn more by exporting to the international market where retail oil prices are much higher than in Mainland. Of course, it's BS to use typhoon as an excuse.
It's proven that price control is the worst makeshift for containing inflation. Heavy subsidies for oil products by Asian governments, including China, significantly aggravate their fiscal budget since mid-2004. Inflationary pressure is only temporarily concealed, market would use methods other than price to reach equilibrium if the use of price is suppressed. Therefore, price control would creates more problems than it solves.
Posted by: Kai at August 17, 2005 08:41 AM
The paper that Max pointed us to above is definitely an interesting one in this regard. I didn't get it all on a first read - I need to read it again - but essentially it's proposing a model of the world in which you have no idea how much oil is there to begin with, and no idea where to look. As you poke around, you learn the kinds of places that have oil, and this helps you get better at finding more oil (you gain information capital). So you keep getting better and better at finding it and thus the price of oil gets cheaper and cheaper. However, you never really know how much is there (the URR) with any reliability until pretty close to the end when you've really mapped the place, and then it starts to become clear the finite amount that's left. Then prices go through the roof. If the paper is sound (I haven't understood it thoroughly enough to be sure yet) it might make an interesting model for what's happening now.
I wonder about Venezuala. It's production has declined significantly in the last few years, and Chavez has been making all kinds of interesting noises:
Colonel Chavez is clearly not planning on using the free market to allocate his oil. He's stated very clearly he believes that oil is peaking and there's going to be a crisis:
and I wonder if he's already communicated to the national oil company that there's really no rush to get the stuff out of the ground.
In fact, in general, given that the big producers have better information than the consumers in this market, if there is a peak soon, you might expect to see Saudia Arabia and Russia behaving similarly (eg cutting Yukos off at the knees to stop it stripping its fields so quickly).
Posted by: Stuart Staniford at August 17, 2005 11:25 AM
Stuart, good summary of Reynold's concept. I think he provides a convincing explanation for why Hotelling's Principle -- which states that the cost of extraction increases as the mine goes deeper -- has not been generally observed for oil and other minerals... not YET, anyway.
Reynolds suggests that cheap energy, i.e., fossil fuels, act as an "entropy subsidy" to compensate for increasingly energy-intensive extraction of increasingly diffuse or remote nonrenewable natural resources. The common perception that technology has sustained economic growth is misleading -- more emphasis should be placed on the contribution of cheap energy. Once the fossil fuels themselves approach their Hubbert peak, these subsidies literally fall off and the true costs of our energy-dependent economies emerge. In another paper (not online) Reynolds refers to the Hubbert curve (or its equivalent) as the inelastic limit of supply.
Reynolds is also saying that information acts as a kind of anti-subsidy. As you imply, once enough information is known about reserves and scarcity is bounded, prices may respond through supply manipulation. It might be more accurate to speak of an "ignorance subsidy" since the less we know about the URR the more favorable for prices. When that bell curve starts rolling over or flattens out ("plateau oil"), the jig is up.
I think that right now markets are able to rationalize higher oil prices by attributing the run up to reduced investment back in the late 90s due to depressed prices. That, and Chinese demand. To my mind the more compelling argument for a nearer-term peak is the relentless monotonic downward trend in the discovery curve which peaked back in the 60s despite technology, despite the price shocks of the 70s, and despite the introduction of Alaska the N. Sea production which appear as mere bumps about the mean decline. Add to that the doubling of OPEC reserves in the late 80s which coincided with a change in oil quota rules. i.e., politics.
Reynold's basic premise -- that the economy can be "fooled" into believing that scarcity is declining when in fact it is increasing rapidly -- seems highly plausible and is a good explanation for why no one can agree on the timing.
Posted by: Max at August 17, 2005 03:18 PM
I'm not familiar with "Hotelling's principle", but I would think even for "normal mined stuff", that you have two competing effects: as time goes on a mine gets played out, as time goes on mining/geology techniques improve. I don't think this is an amazing insight...
First effect is only relevant to an individual mine (as opposed to the set of all mines, to include new ones found with new techniques) with depletion rapid enough that mining technology has not improved.
Posted by: TCO at August 17, 2005 04:27 PM
TCO, the point is that perhaps too much credit is given to technology when in fact energy subsidies have kept prices low despite increasing scarcity. And all technology requires energy.
Posted by: Max at August 17, 2005 05:01 PM
oh...I guess nothing has occurred in terms of advances in geophysics detection or deepsea mining.
Posted by: TCO at August 17, 2005 08:28 PM
What part of a 40-year trend of discovery decreases don't you understand?
Posted by: Max at August 18, 2005 09:48 AM
China slowing crude oil "demand" (or should we say, allowable use) by certain heavy industrial sectors but future refinery greenfield expansion plans still in place according to Chinese oil analysts, via Yahoo! finance
Posted by: Jonathan at August 18, 2005 10:17 AM
I guess the rate of decrease purely reflects us running out of oil. That no change in that rate occurred because of advances in tech. And that proven reserve levels have been dropping...
Posted by: TCO at August 18, 2005 07:37 PM
A couple of quick comments:
1) To answer John's question, just talked to someone in Shanghai, currently per litre of petrol costs 4.28 yuan, a bit more than half a dollar. (Just to give some ball park numbers, a mini van produced by joint ventures costs around 100,000 yuan, and an auto license in Shanghai costs around 50,000 yuan.)
2) I think people have been taking Chinese official numbers way too serious: GDP growth in China has been in a range of 7.5-9.5 percent for the past how many years? Does anyone really think this kind of low volatility (for very high rates) is possible? In comparison, the US GDP growth revisions are sometimes in the range of 1 percent.
Posted by: pat at August 18, 2005 09:08 PM