Indicators point to a Chinese economic fall that could send a shock wave that will cut oil prices.

China's economy is racing upward like a skyrocket as the gross domestic product climbed 9.1% during 2003, including a 9.9% growth rate in the fourth quarter and a 9.7% growth rate in the first quarter this year, according to Cambridge Energy Research Associates (CERA).

In a report titled "Riding the Tiger: The Global Impact of China's Energy Quandry," Daniel Yergin and Scott Roberts, said during that period, which included a SARS disease scare, the nation passed Japan in demand to become the world's second largest oil consumer, after the United States.

"The global oil, gas and coal industries - and increasingly power as well - are now coming to terms with China's emergence, not merely as a new player, but increasingly one of the most decisive factors in their markets. Between 2000 and 2003, China accounted for nearly 40% of the total growth in world oil demand," they said.

China consumed 6.09 million b/d in January, but that number climbed to an average 6.17 million by the end of the first quarter, up 18.5% for the year, according to the International Energy Agency. The agency forecast a 20% year-to-year gain in the second quarter.

If it keeps going at this torrid pace, China will absorb 9% of the world's oil in 2010, up from 5% now, the CERA study said.

The situation is similar to the country's coal industry. From a coal exporter in the early 2000s, industrial and power demand caused shortages in many provinces in 2003. The state opened production channels just to try and keep up. According to the CERA report, "The explosion in energy demand in China has been the primary reason for a doubling in the world price for thermal coal and a tripling in the price for metallurgical coke. The economic boom in China has doubled both the price for coal and the cost of vessel transport."

Most experts blame China's growth for a substantial portion of the continuing climb in oil prices, as well. A fear of running low on oil supply lies in the background. John Westwood, principal in Douglas-Westwood, said, "Any growth in global economic activity increases oil demand such that at 1% demand growth a production peak occurs in 2016, at 2% it occurs in 2012, and at 3% it occurs in 2008. The world's known and estimated yet-to-find reserves and resources cannot satisfy even the present level of production of some 76 million b/d beyond 2020."

China is trying to fill its energy needs. The preferred method for operating outside the country calls for one of the state-controlled oil companies to lock into a supply and to take an equity position in that supply.
For example, it arranged with Australia's North West Shelf group to get liquefied natural gas (LNG) supplies for a new terminal at Guangdong, but it took an equity portion of the expansion project that will supply gas for the LNG plant.

It made the same kind of arrangement for LNG supplies from BP's Tangguh operation in Papua New Guinea, Indonesia, for a terminal in Fujicon, and it made a similar arrangement for supplies from ChevronTexaco's Gorgon giant gas field off the west coast of Australia.

China's production

China's offshore oil company, CNOOC, has announced plans to raise annual production to 293 million boe by the end of next year, and increase that number by 50% by the end of the decade. It wants to raise gas production to 353 Bcf by the end of 2005 and triple that number by the end of 2010.

Sinopec, one of the onshore oil companies, has spent $362.3 million in Xinjiang Province in the past 2 years and plans to spend another $5 billion to drill 776 wells in the area by 2020. By that time, it expects to add 12.1 billion boe of reserves principally in the central Tarim Basin and the southern and central Junggar Basin.

Pipelines

With new gas coming to the coast from offshore fields and LNG terminals, and huge supplies of gas lying in sparsely populated areas in the Tarim Basin of northwestern China, pipelines are big business.
Last October, China conducted its first test of the West-East pipeline, a 2,500-mile (4,000-km) giant that will move 424 Bcf gas a year from northwestern China to the Shanghai area.

That won't be enough. Kazakhstan and China have agreed to cooperate on a $2.5 billion pipeline to bring oil from Kazakhstan to western China with a completion date in 2005. Kazakhstan has already completed the western part of the 1,863-mile (2,000-km) line in that country. Kazakhstan sees the line as an outlet for supergiant Kashagan field and other discoveries in the Caspian Sea.

Major gas supplies will come from Kovykta gas field near Irkutsk in western Siberia. China and Russia have already conducted feasibility studies on the 2,570-mile (4,138-km) line. The line will bring gas to Shenyeang, Beijing and Dalian before crossing under the West Sea to South Korea.

BP-TNK has committed to spend some $650 million in the surrounding area to get the 70-Tcf Koykta field ready to ship gas.

Declines

It's not all gravy. The nation's largest field, Daqing, will cut production by 12 million bbl this year from the 355 million bbl it produced in 2003, according to an Agence France-Presse report.

Field declines are not unusual, but other indicators are popping up that may cause potential investors in China to pause.

"How Beijing resolves its energy challenges will not only be felt within China, but will also reverberate around the world. The aftershocks will be lasting. China's growing weight in world consumption virtually assures a heavy long-term impact on energy prices, trade and investment," said the CERA report.
"The pace and direction of China's short- to medium-term development is therefore less certain - and far more volatile - than most observers now anticipate. Indeed, there is the possibility within the next several years of a more significant slowing of growth, or worse, a so-called hard landing. Such new uncertainties are an uncomfortable consequence of China's expanding gobal role," it added.

Problems?

Even with the petrochemical industry apparently booming and car sales surging, BP has sold its 1.2% share of Sinopec, the nation's largest refiner. Last year, it sold its 2% share in PetroChina for $1.3 billion after the stock had tripled. BP said the sales don't affect BP's plans to spend $3 billion in China over the next 5 years.

PetroChina, operator of the West-East line, has been able to find firm take-or-pay contracts for only half of the 424 Bcf/year it expects to move to the east coast from the Tarim Basin.

In addition, Royal Dutch/Shell, Exxon Mobil Corp. and OAO Gazprom had committed to sign on for a 45% stake in the West-East line, but they still are negotiating over terms on the $4 billion line with PetroChina.
According to a Xinhua News Service report, a Chinese official said Shell was holding out for a 15% return on investment, which PetroChina found unacceptable. Shell denied the report.

That may be a symptom of a major looming problem. Near the end of April, the China Banking Regulatory Commission suspended all lending for 3 days. It quickly denied the order when news agencies picked it up, according to the Stratfor intelligence service.

Any explanation of that move means that "there are extremely serious problems with China's economy in general - and with its banking system in particular," and the issue is whether the move indicated panic or just deep concern.

The situation, however, is a result of the structure of China's economy, which might be following previous meltdowns in Southeast Asia and Japan. Both of those areas had sharply expanding economies and overblown expectations by Western lenders, just as China is experiencing now, Stratfor said.

Economics

"The core problem in Asia - a problem that the Chinese government is trying to address belatedly - is that its banking systems do not allocate capital based on market forces. Loan decisions are made out of political and social considerations, and real interest rates vary depending on these relationships," Stratfor said.

In addition, money for the growth comes from direct loans rather than equity, for the most part. It's hard to sell stock when government policy doesn't allow shareholders to control the actions of the board. It also means that maximizing shareholder value is not a prime goal and rate of return is not critical.

Since direct loans are the fuel, cash flow to repay those loans is critical. And since China lacks a retirement system, people tend to save their money, particularly since they can't invest in companies that work for a return. A strong savings economy also leaves less money for consumption, which means the system depends on exports.

Export dependence mean goods sell near cost to generate maximum cash flow to cover debt service, and climbing debt continues to bolster growth, the intelligence service said. Growing volumes of bad debt cause constant restructuring.

That, combined with investments from foreign companies that may have no control over the way Chinese-run partners spend invested funds, creates a big problem.

"This hollows out the banks. At a certain point, the cash flow requirements outstrip debt service and export demand, and foreign direct investment can no longer make up for them.

"The system erodes slowly but the perception of systemic failure comes suddenly. The banks, working with the government, hold things together until they can no longer do so. A crisis builds around the public realization that major financial institutions are failing, vulnerable to failure or can survive only through heroic measures. A period of sharp, intense crisis takes place, which does not solve any fundamental problems. A long period of malaise follows as some recover and others fall," Stratfor added.

Investors already "have seen a major outflow of money from China by individuals and institutions that know the jig is up," it said.

The government may be able to provide the economy with a soft landing instead of a hard one, but investors in China's economic miracle should perform due diligence before grabbing the Chinese tiger by the tail.