China risk: Alert Oil price shock would hit China hard

THE ECONOMIST INTELLIGENCE UNIT

SUMMARY
China is exposed to oil price fluctuations due to its dependence on oil imports, and a sustained spike in prices a major risk although not our baseline forecast could see manufacturers margins hit and higher inflation. China's fuel-pricing policies create problems for its oil companies, and in the event of a significant spike in oil prices oil-fired power plants could be prevented from passing on the full increase in power prices to consumers, leading to problems in power supply in some areas. Meanwhile, China would experience a major negative impact from higher oil prices through the trade channel, as an oil price spike derailed the recovery in its Western markets.

Price spike
The recent increase in oil prices has reflected turmoil in Libya and elsewhere in the Middle East and North Africa, as traders fear that turmoil could spread to countries central to global oil supply, such as Saudi Arabia. Oil prices spiked to over US$100/barrel in February and over US$115/b for Brent crude by March 7th (compared with prices below US$13/b as recently as 1998). Long-term trends are also at play: demand for oil in China, India and other emerging economies, is rising rapidly.


The price of dated Brent is likely to average more than US$100/b in the first half of the year, but as long as the physical disruptions are limited to Libya, the price should ease thereafter. A number of factors potentially mitigate the impact of the situation on the oil market. OECD oil inventories are high by historic standards, and OPEC members have ample spare capacity that could be brought into play should it be necessary to increase production. Still, the risk of a more sustained spike in prices is considerable. The collapse of a Gulf monarchy would set a potentially game-changing precedent, and the oil markets would be likely to take fright even if neighbouring Saudi Arabia remained stable.

This would have major implications for China, which has now emerged as the second largest importer of oil in the world, with imports of crude oil rising by 17% in 2010 to 239m tonnes. This leaves China dependent on imports for 54% of its demand, and it is likely that imports will rise further this year and in the years ahead. Even assuming that slower GDP expansion lowers the pace of growth in China's demand for oil this year, the country is building a strategic oil reserve that will be completed in 2020. The state-run media confirm that further action on filling this reserve will be undertaken this year, underpinning global prices.

Pressure on margins
China's power production is largely coal-fired, which helps to reduce the direct exposure of its manufacturing base to oil prices. Nonetheless, given China's central role in global manufacturing chains, a large rise in oil prices would hit manufacturers margins and potentially have a knock-on effect on the country's foreign trade performance, as Western consumer sentiment remains fragile. This would particularly be the case in terms of China's use of petroleum in the production of naphtha, which is used to manufacture plastics and a range of consumer goods.

China's oil refiners will be most directly affected by higher prices for imported crude, not least because of the way the Chinese government intervenes in the fuel market to restrict price increases. Diesel and petrol prices (diesel and petrol use account for around half of China's oil consumption) were raised by 4.5% in February, following a similar rise in December, but the government did not allow the full rise in global prices to be passed on to consumers. And given concerns over rising inflation in China, it remains likely that the government will prevent a full pass-through of price raises later in the year, too. Such price controls shield petrol users, and thus China's own car-making industry, but have resulted in petrol rationing in the past.

This would put China's oil refiners in the awkward position of having their margins cut by state fiat, or even having to produce at a loss. The state-owned oil refiner, Sinopec, is reliant on imports for 80% of its crude, directly exposing it to global price trends: when oil prices spiked in 2008, the Chinese government was forced to subsidise oil refiners. Such an outcome could not be ruled out if the more lurid forecasts for oil prices were fulfilled this time round.

Finally, there is the impact on power production. In most parts of China power is coal-generated, but parts of the important south-eastern manufacturing base are dependent on oil-fired plants for a significant proportion of their power supplies. Power prices are also controlled by the government, giving rise to the possibility that, in the event of a large spike in oil prices, some power plants may be forced to operate at a loss. As a result, brownouts (a recurrent problem in China) would be likely. These tend to lead to a spike in diesel demand for diesel generators, as companies seek to cope with reduced supply from the power grid. Such an effect was seen in the fourth quarter of 2010, when government targets for reduced carbon emissions led to a reduction in power supplies and a sudden spike in diesel usage. This though would put more pressure on companies' margins in a context of higher fuel prices (even if price controls prevented the full increase from being passed on).

Impact on prices
The impact of higher oil prices on China's consumer price inflation is a key consideration. Although fuel is thought to have a weighting of only around 1% in the consumer price basket, it affects costs of other components. The role of oil prices in squeezing industry margins could lead to a more significant increase in prices. It is true that increases in producer prices cannot always be passed on, but sustained pressure on margins would be likely to have an effect on consumer prices, too. A further consideration is the widespread use of diesel in agriculture. Higher diesel prices could push up agricultural and food prices, and, thus, the overall consumer price index.

China has set a target for inflation of 4% this year, but the January figure already exceeded this at 4.9% year on year. Higher oil prices come on the back of higher grain prices, leading to concerns that China's mainly domestically-generated inflation may be supplemented by imported inflation. Inflation rates are already nearing acceptable limits for the authorities, and higher rates could have economy-wide effects, as the government was forced to tighten its policies in terms of interest-rate increases, banks� reserve requirements and credit controls to prevent inflation from spiralling further.

Impact on trade
China also faces a major risk to its external trade through the impact of oil prices on Western economies. A weakening of the recovery in the West, or even renewed recession in one or more economies, would hit demand for China's exports, even as China's domestic economy struggled with oil-driven inflation and interest-rate rises. China's foreign-trade profile is considerable source of indirect exposure to global commodity price trends.

Furthermore, with Chinese, Indian and other emerging market demand for oil likely to continue rising rapidly and with less room for a ramping-up of oil supply than was the case in previous oil shocks, oil price volatility boosts the profile of oil security. This issue is being addressed by China both by building of strategic reserves and by global investment in oil resources. However, many of China's key oil investments are in rogue states such as Libya and Sudan, and other politically unstable countries such as Angola, and recent attacks on its oil installations in Libya call into question China's strategy in this regard. A spike in oil prices driven by events in the Middle East would not only hit China's economy hard, but would also raise difficult questions about the country's investment strategy.

Source:
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