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The US-China trade war may escalate to energy

A trade reconciliation between Washington and Beijing may come too late for the US oil and gas industry

If China's leadership can draw one lesson from 2019, it is that there are risks to relying on other nations. US export bans on technological components to ZTE and Huawei raised questions about the wisdom of relying on the US for critical inputs to the economy. While the focus has so far been on technology it is certainly possible that the US could extend this to energy, which is similarly vital to the functioning of the Chinese economy.

While China has little or no direct exposure to US energy exports, it does not mean that China is immune to US policy. The recent US blacklisting of dozens of tankers operated by Cosco has resulted not only in a spike in very large crude carrier (VLCC) rates but also created a logistical nightmare for Chinese oil traders. Energy has the potential to be one of the most attractive options to reduce China’s trade deficit with the US; but trust has evaporated in the short term, and even more so for the long-term energy supply agreements that are essential to enabling the next leg of growth for the US LNG industry.

Energy matters because it underpins China's economic rise. Without access to energy, China's economy would grind to a halt. Not only is China the largest consumer of primary energy, but it is also the largest importer of oil and gas globally. After imports of electrical equipment—which often get re-exported—oil is the next largest item on China's import bill.

Energy security

With relatively low per capita reserves of oil and gas, China is expected to become increasingly reliant on energy imports to meet demand. Last year China's dependence on imported energy increased to 20pc, the highest level on record. This will likely rise to 30pc by 2030, which will make China's energy security risks only greater. For the Chinese Communist Party, energy security comes second only to social stability on the list of things to worry about. And with growing worries in Beijing around the impact of a trade war with the US, there are clearly heightened anxieties.

Among Chinese planners, there is concern that US naval supremacy exposes a key weakness in China's energy strategy. Most of China's imported oil and a large quantity of its LNG passes through the Strait of Malacca and a handful of other passages that the US Navy could seal off. The easiest way to bring China's economy to a halt would be through a naval embargo. While China has alternative crude oil pipeline supply routes through Myanmar, Russia and Central Asia, these would be insufficient to make up for the shortfall.

15pc — China’s target for gas in its energy mix

In response to increased trade tensions, China has refocused efforts on domestic oil and gas production growth. In July 2018, President Xi Jinping told major oil companies and government agencies to implement measures to increase domestic oil and gas production. All three oil majors have significantly ramped up domestic E&P capex this year in response.

But there are limits to what can be done. China's oil production peaked at 4.3mn bl/d in 2015 and has fallen back to 3.8mn bl/d due to the shut-in of unprofitable fields. While China is reporting growth again in oil production, there is little that can be done to dramatically increase production and certainly not enough to keep up with the underlying growth in demand of 3-4pc, or 500,000bl/d. As such, oil imports will only continue to rise.

Similarly, China's rapid growth in demand for gas has resulted in a rapid growth in gas imports, to the point where China is now the largest gas importer in the world. China's gas market reached 272bn m³ in 2018. Of this, 152bn m³ of gas was domestically sourced, with 120bn m³ of imports (44pc import dependence) in the form of pipeline gas (51bn m³) and LNG (69bn m³).

Rising demand

China wants gas to reach 15pc of the energy mix by 2030, which implies demand of 600bn m³ by 2030. Assuming domestic gas can meet half of this, imports will reach 300 bn cm³. This implies incremental pipeline gas supply from Russia or LNG of 100bn m³, which is equivalent of adding a new Japan over the next 10 years.

If China and the US are heading for a state of hostile co-existence, then China could try to curb demand for oil and gas as well as taking steps to boost supply. This would clearly be negative for oil and gas markets given the key role China plays as an end-consumer growth market; it is predicted to account for almost 40pc of incremental global oil and gas growth over the next decade.

While China is throwing everything it can at tight oil and shale gas, there are limits to what can be achieved. It seems inevitable that imports will continue to rise. The US loss would be a gain for others. Australia and Russia in particular, which are the largest suppliers of energy to China today, are likely to be the winners from a limited deal between the US and China.

Neil Beveridge is a senior oil analyst at Sanford C Bernstein

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