China to dominate global energy demand
As the superpower spat continues, can the US close the trade deficit by targeting China's booming energy needs?
For oil and gas investors, there is plenty to ponder as we enter 2019, which looks a much tougher year for the industry. Opec policy and Iran are some of the obvious, but the biggest strategic question is the outcome from US-China trade negotiations. Combined, both countries account for 40pc of global energy consumption and GDP. An ugly trade spat could sharply slow global growth with negative repercussions for oil demand and oil prices. On the other hand, a rapprochement between both superpowers could unlock a new phase of energy co-operation. While the latter seems less likely, the outcome of US-China trade negotiations will have a significant impact on global energy demand and energy trade flows next year and well into the future.
US displeasure with the size of trade deficit with China continues to grow. Despite protestations from President Trump, the deficit is likely to exceed $400bn this year. But the discord between the US and China runs deeper than just the trade deficit, and includes a raft of other issues including market access and intellectual property rights. The US-China relationship has fundamentally shifted to one of strategic competition.
Reduction of the trade deficit requires either China to export less to the US or for the US to export more to China. If sustained global economic growth is the preferred outcome, then the best outcome is for the US to export more to China. Putting aside soybeans and aircraft, energy is the only realistic way to close the trade gap. A decade ago, China and the US were competitors for international oil and gas assets. Since then, however, there have been two fundamental shifts which make China and the US more likely to collaborate than to compete.
The first is growth. China's energy market is now substantially larger than the US. A decade ago the US was the largest consumer of primary energy. Today, China's energy market is 40pc bigger. US demand for primary energy has actually declined since 2008, while China has seen energy consumption continue to grow at 4pc compound annual growth. Despite this, US energy consumption per capita is still three times larger than China. Assuming China can continue to grow its economy at a mid-single digit growth rate, it will remain the single largest contributor to global energy growth. China is already the largest importer of crude oil in the world, with imports of close to 10mn bl/d. According to the International Energy Agency (IEA), China will remain the single most important country for oil demand growth through to 2030. In 2018, China set another record by overtaking Japan to become the largest importer of natural gas, with imports of 112bn cm. Given China's commitment to growing natural gas to 15pc of the energy mix, annual gas consumption will more than double to 600bn cm by 2030, which will suck in yet more imports. For any energy exporter, China remains the lynchpin of global demand.
Undoubtedly, oil and gas can play a key bridge in mending US-China relations
The second shift is shale. The US is now less dependent on foreign energy than at any time in its recent past. This has fundamentally altered the pattern of global energy trade flows. US oil imports are declining as US production backs out of 'foreign oil'. With surging shale gas production, the US is now a net exporter of natural gas helped by a wave of LNG export terminals. Contrast this with China where there is no shale revolution and unlikely to be so. China's oil production peaked in 2014 and has declined by 0.5mn bl/d since then, exacerbating the dependency on imports. While domestic gas production continues to grow, production cannot keep pace with demand, causing LNG imports to grow by 30pc in 2018 alone. Looking forward, these trends will continue. By the end of the decade the US will be self-sufficient in oil and gas, while China will be increasingly energy insecure.
But for the US to grow oil and gas production beyond indigenous demand, oil and gas must be exported. The most logical destination market is China. Already, nearly 10pc of US exported oil goes to China. China is also the third largest destination for US LNG exports. While the US does not need the China market per se to expand oil exports (given the liquidity of global oil markets), the US does need China if it is to expand its exports of LNG. Over the next decade, China will account for 40pc of global LNG growth. No other market comes close. And unlike oil, LNG projects still need long-term buyers to underpin investment in liquefaction terminals. How much LNG gets exported by the US will depend on what buyers want, not sellers.
So far, the US has over 60mn t/yr of LNG operational and approved, with a second wave of 100mn t/yr of projects ready to go if buyers step in. Unless China steps up to the plate, a second wave of US LNG projects is unlikely to materialise. The issue is political, not commercial. Assuming Henry Hub prices trade around $4/ mnBtu (real), then this should be competitive with oil-linked LNG at around $70bl. Putting aside the pricing risks of buying US LNG on a hub-linked rather than oil-linked formula, the central question is whether China wants to be beholden to the US as a major supplier of energy in the future. Some would say that it would be dangerous for China to rely on the US for energy given the new era of strategic competition, but this would be short-sighted.
Firstly, US LNG offers geographic diversification of supply. More than 60pc of China's LNG comes from Qatar or Australia. Security of supply comes from diversification and the US can certainly provide this. Secondly, Henry Hub-linked LNG offers price diversification. No one can predict the relative spreads of oil and gas over the next 30 years, although the smart money would be that US natural gas prices will remain depressed relative to oil prices given the abundance of resources. As we have seen from buyers in Japan and Korea, Henry Hub offers diversification away from oil price, which must be a source of value. Third, by encouraging US LNG, China is encouraging competition in the global LNG market. China's self-interests are served by maximising the numbers of countries which export LNG to create as much competition as possible. By excluding what could be one of the largest LNG exporting countries, it would limit competition. Finally, and most importantly, US oil and LNG imports to China will reduce the trade deficit, which is a pre-requisite for improving relations.
10mn bl/d—China's crude oil imports are the biggest in the world
While oil and gas cannot eliminate the trade deficit, it could reduce it. At US$70/bl, 1mn bl/d of oil exports is worth $26bn. 20mn t/yr of LNG exports at a Henry Hub price of $4mn British thermal units, is worth $9bn. If the US were to capture a 10pc share of oil and gas China imports, this would be worth $35bn annually at $70bl. A 20pc share of China oil and gas imports would be worth $70bn. While this would not eliminate the annual trade deficit, it would put a significant dent in it.
Undoubtedly, oil and gas can play a key bridge in mending US-China relations. An analogy is the relationship between Russia and Europe during the Cold War. Russia supplied Europe with gas for heating, while Europe supplied Russia with valuable foreign exchange reserves. Both were mutually dependent on each other. The same logic applies to the US and China. China receives clean-burning natural gas which will help reduce air pollution while the US finds a market for the vast reserves of gas which could be stranded. By displacing coal, such a bargain would also be positive for the environment and help lower greenhouse gas emissions.
While there are many permutations for how the US-China trade deal could play out, it ultimately comes down to deal or no deal. If there is a deal, it would be positive for global growth, global energy demand and global commodity prices. We suspect it would be good for US LNG exporters, and incrementally negative for international LNG producers in Australia, Russia and Qatar. But if there is no deal, then expect global energy demand and commodity prices to take a hit. In this case no one will be a winner, given the likely reduction to global economic growth and energy demand. While we hope that the art of the deal may prevail, investors would be right to take a cautious approach in evaluating what may lie ahead.
Neil Beveridge is Senior Oil and Gas Analyst at Sanford C. Bernstein