has the ox come of age?, page-11

re: research out!! thanks tastarga, good informed views

btw crassus, i can think of a very good reason why smith barney classed this as high risk ... simply because it's a resource stock buddy. there are no guaranteed bets in this industry i think. for e.g. if china's economy busts copper will tumble and the ox will tank. and there is at least one reputable firm (morgan stanley, and its asia pac economist andy xie) who thinks china's economy will have a hard landing, taking oil and copper prices down with it. these appear to be 'shock jock' type pieces to me but at least in the past xie has had a pretty good track record.

Asia/Pacific: Oil vs. Coal

Andy Xie (Hong Kong)

Summary and Investment Conclusion
An electricity shortage exaggerated China’s demand for oil and refined products last year as most export factories bought diesel generators to cope with the shortage, which may have accounted for 350,000 bbl/day in China’s oil demand. Macro overheating also exaggerated China’s crude demand import by 14-20% or 300-500,000 bbl/day.

However, China’s electricity generation capacity should catch up with demand in 2005. As the Fed continues to increase interest rates, China’s GDP growth rate and energy demand are normalizing. China’s imports of oil and related products may fall in 2005 and not increase much in 2006, in my view.

Coal prices should remain strong, due largely to the rapid growth of electricity generating capacity at least in the short term. In the medium term, China has to modernize its coalmining industry to reduce mining fatalities and increase production. This will take several years and the coal supply-demand picture should remain tight.

Electricity Shortage Exaggerated China’s Oil Demand
China’s fixed investment and exports doubled between 2001-04 due to the declining US interest rate and dollar. Fixed investment and exports accounted for over half of China’s GDP in value-added terms. The extraordinary economic growth triggered a massive increase in energy demand.

Electricity production increased by 13.3% in 2002, 14.2% in 2003, and 14.6% in 2004 compared to an average growth rate of 8% in the preceding two decades. The electricity system was unable to handle the demand and severe blackouts began in 2002. Provincial governments were sending out production stoppage orders to factories.

As the export sector could not delay production to fulfill their orders it began buying diesel generators to keep factories running. China’s imports of refined petroleum products rose by 38.7% in 2003 and 33% in 2004. The cumulative increase in the imports of refined products was 17.2 million tons over these two years, which, if we assume a 50% conversion rate between crude and refined products, would be equivalent to 690,000 barrels per day.

Electricity Production Is Catching Up with Demand
China’s electricity capacity increased to 440 GW from 384 GW last year. The estimated capacity shortage was 20-30 GW last year but it seems there will be sufficient capacity in 2005. As electricity from diesel generators is more expensive than from the grid, the export factories should switch back to the grid for power supply again.

How much of the fuel imports went towards electricity production is unknown. But we do know that China’s imports of refined products grew slowly until the electricity shortage began. There is also widespread anecdotal evidence to suggest factories were running on electricity provided by diesel generators. My estimate is that half of China’s import growth for refined products could be due to the electricity shortage. Hence, 3.45mn bbl/day of China’s oil demand could be at risk as electricity generating capacity catches up with demand.

Oil Prices Should Decline in 2005
China’s crude imports rose by 50.6 million tons in 2002-04 or a million barrels per day. In my view, the economic overheating probably exaggerated China’s crude imports by one-third to a half, this is equivalent to 14-20% of China’s total crude imports. As the Fed continues to increase interest rates, China’s GDP growth rate and energy demand should normalize. Hence, China’s oil imports in the next two years could decrease by 350-500,000 bbl.

While China’s long-term demand for oil is robust, the short-term outlook appears quite weak. The macro normalization and the expansion of electricity generation capacity could cut China’s imports by 500-750,000 bbl/day. I suspect that China’s imports of crude and refined products will fall in 2005 and barely rise in 2006.

Energy Consumption Shifts to Coal
As grid power use increases in China, coal prices should remain strong and I believe that China will face a coal shortage in 2005 and 2006. China consumed about 1.9 billion tons of coal last year, up 20% from 2003. China has underinvested in the coal mining industry, because, until last year, coal prices were quite low. Chinese coalmines used labor to substitute for capital, which is the main reason for the high fatality rate in the industry (5-6 deaths/million tons on reported numbers). If each life lost were compensated in China as they are in OECD countries, China’s coal mining industry would not create value.

I believe China has to embark on a multiyear capex program to modernize its coalmining industry to make it safer and increase production to satisfy demand. In the meantime, China will have to import a lot of coal to satisfy its domestic demand. China’s imports rose 69% but were still small at 1% of the total demand. I believe that China’s coal imports will continue to rise rapidly, possibly doubling every two years, for the foreseeable future.

Further, China’s coal production cost has to rise. The high fatality rate in the industry shows that coalmines have been sacrificing safety to keep production costs low. However, China’s political and social environment is becoming less tolerant of big industrial accidents. China’s coal industry has to consolidate and modernize, and this will likely boost coal prices.

As an aside, the increase in electricity generating capacity should halve this year in China and this is bearish for copper. Copper consumption grows proportionately to electricity capacity as most demand for copper in China goes into the electricity sector, including distribution and generation. For 2005, I am bullish about coal, bearish about oil and copper.