How Can China Impact Crude Oil Prices In 2016?

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The year, 2016, has started on a shaky note for the commodity markets. The global benchmarks for crude oil – Brent and WTI – have plunged close to 20% since the beginning of the year, hitting their 13-year lows of under $30 per barrel, as the market reacted to the slower-than-expected economic growth in China, the world’s second largest economy. Since China accounts for a large share of the global demand for oil, a slowdown in its economy is likely to result in a further decline in crude oil prices in the coming months. Additionally, the depreciation of the Chinese Yuan, and the rising debt levels in the country, have been adding to the insecurities of the investors across the globe. Hence, in this article, we aim to discuss the economic conditions prevailing in the Chinese economy and their potential impact on  crude oil prices over the course of the year.

oil-jan16

Source: Bloomberg

Slowdown In The Chinese Economy

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Before discussing the impact of a weak Chinese economy on the oil prices, let us look at the country’s position in the global oil market.

According to the Oil & Gas Journal (OGJ) (released in January 2015), China holds 24.6 billion barrels of proved oil reserves, which is the highest in the Asia-Pacific region (excluding Russia). Over the last two decades, the country’s petroleum production has grown by more than 50%. However, this production growth has not been sufficient to meet its domestic consumption, which has been rising exponentially due to its extraordinary economic growth. According to the US Energy Information Administration (EIA), China was a net exporter of oil until the early 1990s, but became the world’s second largest net importer of crude oil and petroleum products in 2009 due to its thriving economy. In fact, China surpassed the US to become the world’s largest net importer of petroleum and other liquids in 2013, on the back of its rising oil consumption. In 2014, the country produced almost 4.6 million barrels per day (bbl/d) of petroleum and other liquids, against its consumption demand of close to 10.7 million bbl/d.

China-oil

Source: US Energy Information Administration (EIA)

However, over the last couple of years, the country has purposely moved from a manufacturing-oriented economy to a service-driven economy, using a less-energy intensive approach to growth. As a result, the demand for crude oil in the world’s largest oil consuming country has gone down drastically. In 2014, China’s oil consumption growth accounted for about 43% of the world’s oil consumption growth. But, due to the sluggish Chinese demand for oil over the last year, EIA projects that the country’s contribution in global oil consumption growth will go down to almost 25%. Although the decline in Chinese oil consumption is huge, the country continues to account for a significant proportion of the overall consumption growth.

China-oil7

Source: US Energy Information Administration (EIA)

While the market had factored the structural changes in the Chinese demand into the crude oil prices last year, it had expected the overall economic growth in the country to make up for the oil demand in the long term. However, to everyone’s surprise, the China’s economic growth for 2015 averaged close to 7% as opposed to the over 10% growth that the country had been delivering post the 2009 recession. Since China accounts for more than 50% of the incremental economic growth worldwide, a slowdown in the fastest-growing economy would mean a steep fall in the demand in oil. On the other hand, if the North American shale and tight oil producers continue to play the “who-will-blink-first” game with the Organization of Petroleum Exporting Countries (OPEC), the oil markets are likely to remain oversupplied through the coming quarters. All this would lead to a further drop in oil prices, which could prove to be detrimental for the investors.

Thus, the fear of a potential slowdown in the Chinese economy, and a subsequent recession, has triggered a strong turbulence in the global stock markets since last week, wiping out billions of dollars from the international equity markets, particularly the Asian markets. This is the second instance in the last 6 months, when the fear of slower economic activity in China has prompted an investor sell-off globally. In consequence, the commodity markets saw crude oil trading at below $30 per barrel levels earlier this week, a mark not seen since 2003.

Crude-18

Source: US Energy Information Administration (EIA); Bloomberg

The Great “Fall” Of China

While some may argue that the market is over-reacting to the economic conditions in China, we believe that it has strong reasons to do so. Apart from the slower economic activity, which appears to be the key reason behind the recent turmoil in the global stock markets as well as the commodity markets, the Chinese economy has a lot of debt on its books, much higher than the debt of some advanced economies such as the US, the UK, and Australia. Though the official numbers are unavailable, the market experts believe that China’s debt has been growing roughly twice as fast as its economy over the last 5-7 years.

McKinsey & Company had published a report named Debt And (Not Much) Deleveraging in February 2015, highlighting the rising debt levels in the global economies since the economic slowdown of 2008-2009. According to that report, China’s total debt has quadrupled since 2007 to $28.2 trillion in 2014, while its Gross Domestic Product (GDP) has tripled to $10.4 trillion during the same period. This implies that the country’s total debt was 282% of its GDP in 2014. Now, having a lot of debt may not be a concern in itself as long as the economy is growing at a rate to sustain this debt. However, in the case of China, the debt has significantly outpaced its economic growth over the years, which is the root cause of the entire problem. For instance, the local government debt in China increased almost 47% over 2013-2014, while the fiscal revenue grew by merely 8.6% during the same period [1].

China-debt3

Source: Debt And (Not Much) Deleveraging, McKinsey & Company, February 2015

As previously discussed, China had been growing at a rate of more than 10% over the last 6-7 years. However, for 2015, the country’s economic growth is expected to be around 7%. Thus, the gap between the debt and the economic growth has widened of late, increasing the anxiety of the risk-averse investors.

Further, to make things more complicated, one-third of the country’s debt is directly or indirectly related to the real estate sector. While the property prices in large Chinese cities have gone up more than 60% since 2008, the transaction volumes have dropped by over 10% over the last year. This is building up the unsold inventory in the country, and many market experts are comparing this slump in the Chinese housing sector to the US housing crisis. If the decline in the Chinese housing sector continues in the coming months, smaller players, who are dependent on high-cost debt, may find it difficult to service their debts. Consequently, the country may experience a severe debt crisis, similar to the one faced by the US in 2008-2009.

China-Debt2

Source: Debt And (Not Much) Deleveraging, McKinsey & Company, February 2015

In addition, China has been consciously allowing its currency to devalue against the US dollar to boost its exports. The Chinese Yuan has depreciated almost 6% versus the US dollar over the last one year and close to 2% over the last one month, touching its 5-year lows. While the weaker Yuan will make the Chinese exports more competitive in the global markets, this has intensified investor fears over the economic health of the country and the ability of the policy makers to manage a slowing economy.

US Dollar (USD) to Chinese Yuan (CNY) Exchange Rate (16 Dec’15 to 15 Jan’16)

USD-CN

Source: Bloomberg

Thus, we believe that the economic instability in the world’s second largest economy has the potential to drive the world into a mild recession, if not a major one. If the fears of the investors materialize, and the Chinese economy actually goes into a recession, the demand for oil could touch its all-time lows, further driving down crude oil prices. In fact, who knows, Goldman Sachs’ prediction of a $20 per barrel crude oil price scenario, might actually become a reality.

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Notes:
  1. China struggles to get on top of its debt mountain []