The impact of Chinese energy demand on world energy markets

As the most populous country on the planet emerges from decades of economic poverty, the imports necessary to satisfy growing demand for energy in China are beginning to dominate global energy trading markets. With this influence only increasing, energy companies will find an entirely new spectrum of opportunities and risks.

Growth in Chinese energy demand

The growth in China’s energy consumption levels has been nothing short of extraordinary. In 2016, according to BP, China consumed 3.05 billion tons of oil equivalent (TOE) worth of energy. That’s the most of any country on Earth, about 35 percent more than the United States and representing 23 percent of world total energy demand, according to BP.

China has single-handedly lifted its citizens out of poverty through industrialization. The Chinese “work hard” and for the first time in ages they have the financial backing to “play hard.” China looks to be a disruptive force in the Asian energy markets. They are taking the world by storm and surprising one and all with their dedication to improving China’s energy mix with the acceleration of green energy, as well as their determination to continue developing their shale gas resources, despite difficult geological and technical challenges.

The market

Why is everyone talking about China? Why not India or Malaysia? China continues to amaze the world and is dedicated to transforming the energy markets as we know them today. China has the most oil and gas reserves in the world. They have the most to gain from successfully cracking the shale-production nut.

By 2040, the International Energy Agency (IEA) predicts that Chinese oil demand will increase by a further 4 million barrels per day, before plateauing. The reason for this growth is China’s ever-expanding vehicle fleet and utilization. China has about 300 million registered vehicles, according to the South China Morning Post, which is still only about one vehicle per four people, compared to more than one vehicle per person in the U.S. China must reduce its reliance on crude due to the maturity of its depleting fields and the continued increase in consumption by its growing population.

This surge in demand is not just for oil; natural gas demand is also growing robustly in China. As in other countries, China is making a “dash for gas,” the cleanest of all fossil fuels and increasingly available at lower prices in world markets because of massive expansion of liquefied natural gas (LNG) infrastructure and major increases in supplies from Qatar, Australia and the U.S.

Chinese natural gas demand tripled within a decade to 210 billion cubic meters (bcm) by 2016, or roughly one-quarter the size of the U.S. gas market, according to the IEA. Looking ahead, about one-third of increases in global gas demand are expected to be attributable to China. By 2040, the IEA forecasts China to be the largest importer of natural gas with Chinese gas demand reaching 600 bcm.

Over time, growth rates in Chinese oil and gas demand will inevitably decline, for no other reason than the maturation of the economy. In addition, the Chinese government has announced its intention to prohibit the sale of new automobiles with internal combustion engines, which will accelerate the shift to electric transportation and promote their transition to a cleaner society.

China to become major center of energy trade

To satisfy such growth, it’s an ongoing challenge for China to secure enough energy supplies. Unlike the U.S., China has relatively modest domestic oil and gas resources currently producing energy — nowhere near enough to meet domestic demands. China is only producing its shale at about 20 percent of the rate of the U.S. because of geology, lack of technical skills, inadequate domestic gathering and pipeline capacity, and regulatory barriers.

In 2017, Chinese oil production was about 4 million barrels per day, accounting for about one-third of Chinese demand, and production levels have been falling since 2015. While Chinese natural gas production is continuing to rise, production levels in 2016 of 138 bcm nonetheless covered only about two-thirds of demand levels.

China’s producing fields are generally considered high-cost, and have experienced steep decline curves, with no major discoveries in recent years to replace the declines. According to BP, proved reserves are 26 billion barrels of oil and 4.8 trillion cubic meters of gas — in each case, less than 3 percent of world totals.

Absent an unexpected boon in domestic production, the projected growth in Chinese oil and gas demand can only be met with ever-growing imports of energy. In 2017, China became the largest oil importer, importing 8.4 million barrels of oil per day and for the first time surpassing the U.S., which imported 7.9 million barrels per day, according to the U.S. Energy Information Administration. China’s position as leading importer can only be expected to continue.

Meanwhile, as for natural gas, China is likely to overtake Japan as the world’s largest importer in 2018, at 105 bcm — relative to zero imports in 2006. While a substantial portion of gas imports arrive via pipeline, China additionally imports large quantities of LNG by ship: 38 million tons in 2017.

Chinese energy companies have invested enormously in foreign oil and gas resources, securing large tranches of supply that can last for decades. Complementing these long-term supply chain strategies, volumes of energy imports on shorter-term contracts and spot trades will also likely increase. With developments of this magnitude, it’s clear China will inevitably become one of the most critical trading hubs in global energy markets.

China, Japan and Singapore are all competing to be the first Asian hub for LNG. One could say that China is leading the way with its emergence as a global energy trading center will likely being facilitated by the March 2018 introduction of oil futures on the Shanghai International Energy Exchange, with contracts denominated in China’s currency, the yuan. China’s diverse supply and growing consumption add support to its thirst to develop an LNG hub; however, the government is pretty dominant and the market wonders if China has the ability to promote domestic, as well as foreign, participation in the market.

According to UBS, although it will take time for liquidity to accumulate, the sheer size of volumes of energy being imported into China — along with China’s determined intention to establish its currency as a global reserve currency akin to the U.S. dollar — strongly suggest that the Shanghai oil contract markets will become viable and give China the advantage in becoming the first Asian country to host an LNG hub.

Implications for energy companies

The enormous volumes of energy demand from China will become an increasingly influential factor in price setting for various forms of energy at delivery points around the globe. Even energy companies whose primary exposure lies in markets far from China will need to develop a good understanding of how unexpected movements in Chinese demand affect prices of the energy commodities in their portfolios.

With the introduction of Chinese oil futures contracts — for seven specific benchmark grades of fuels consumed in China, in Chinese currency — an entirely new arena for energy trading is likely to blossom in the coming years. Some of the most common fuels of interest to China, such as Basrah Light, may become as well-known and widely-traded in global energy markets as West Texas Intermediate (WTI) and Brent are today. Similarly, Shanghai will likely become to the Asia-Pacific region what Cushing is to WTI transactions and Henry Hub is to U.S. natural gas markets — the reference delivery point against which virtually all energy trades, physical and financial, will be linked.

As China becomes more central to global energy trade, prices for oil and LNG will more frequently be set based on transactions for markets in China rather than elsewhere. This means improved pricing for oil and gas producers located closer to China — such as Vietnam, Malaysia, Indonesia and Australia — who now often experience downward pressures on pricing of their product to accommodate higher transportation costs to more distant markets (e.g., North America, Europe or the Middle East) where prices are currently mostly set.

Beyond oil and gas, new trading opportunities will emerge from China’s growth in other energy-related commodities. Recently, China announced its intention to establish spot electricity markets, thus bringing all the complexities associated with power trading in even relatively transparent Western economies to the uniquely opaque China context. Regarding the electricity sector, China is planning a carbon market that will apply to thousands of point sources.

For energy companies with exposure to other commodity segments, markets for metals such as lithium and cobalt, which are of strategic importance to batteries (a major industrial development initiative being pursued by China to establish global dominance in electric vehicles), will also be affected by energy sector developments in China.

As with every aspect of the global economy, the rise of China is changing energy markets. No company with a significant energy commodity position can afford to ignore the impacts of Chinese energy demand on their business.