China's Crude Conundrum

The tremendous growth of the Chinese economy over the past two decades has vaulted China to second place behind the United States in oil consumption. But China's ability to continue its current economic growth trajectory is increasingly doubtful, adding to the uncertainty around global demand for many of the commodities the country has voraciously consumed, including oil.

In this piece we seek to answer two key questions pertaining to China's oil outlook. First, if economic growth slows as a consequence of rebalancing from investment-driven to consumer-driven activity, what will happen to oil consumption? Second, what can be expected for domestic production and China's prospects for unconventional oil and gas?

What Effect Will Lower GDP Growth Have on Chinese Oil Consumption?
Chinese GDP and oil consumption have both grown steadily over the past two decades. Gross capital formation has pushed GDP growth and made up a massive 48% of GDP in 2011. We believe lower investment and a rebalancing toward a consumer-driven economy is an inevitable step in China's development. We think consensus forward expectations for GDP growth are overly optimistic at 8%, and believe 5% is a more appropriate rate over the medium to long term. In the context of a rebalanced Chinese economy growing at 5%, is oil consumption growth in jeopardy of falling as well? We don't think so.

Chinese oil consumption growth averaged 6.3% over the past five years, and while annual rates have been volatile, consumption growth has fallen steadily from 14% in 2009 to 4% in 2012, as the price of Brent crude rose from an average of $62 per barrel to $111. Recent economic data from China have been negative enough to suggest that the economy is slowing and might even face a debt crisis brought on by years of aggressive, borrowing-fueled fixed-investment spending to boost GDP.

A quick and naive estimation of the impact of lower GDP would assume the two growth rates fall in lockstep. However, we believe a direct relationship between oil consumption growth and GDP growth (what we will call oil intensity) is actually an overestimation.

Oil Intensity, 1991-2011

Source: China Statistical Yearbook 2012, EIA, Morningstar

Declining oil intensity averages do not suggest that the Chinese economy is becoming more efficient with respect to oil consumption as time passes. Rather, the relationship should be considered in terms of which activity is driving economic growth, and how much oil that activity consumes. For example, construction, mining, and steelmaking are all investment activities that have contributed heavily to GDP growth in recent years, but are nowhere near as oil-intensive as consumption related to transportation or household spending. Comparing our estimated refined product consumption activity from households and the consumption share of GDP indicates that oil intensity of households actually accelerated in recent years.

We expect that China will maintain its pace of oil consumption growth over the next five years. This may seem counterintuitive in the context of lower GDP growth. We believe, however, that the intensity of oil consumption attributable to households is greater than that of investment activity and will increase as Chinese consumers purchase more motor vehicles. Therefore, we expect that even in an economic rebalancing where GDP growth falls, the growth of Chinese oil consumption will remain steady.

Increased Vehicle Ownership Should Drive Oil Demand Growth
Cars and trucks are hitting Chinese roads at a rapid pace. Total private vehicles (passenger vehicles and trucks) grew at an average rate of 19% annually from 2002 to 2011, while net sales grew at an average annual rate of 24%.

As the consumer sector consumption grows, we expect that wealthier households will continue to purchase vehicles that require gasoline and diesel fuel, creating additional demand for oil. To some degree, we are already witnessing this take place. Platts recently reported that its latest estimation of apparent monthly gasoline demand increased "robustly" thanks to motor vehicle sales, up nearly 11% versus the year prior.

We can infer from examining data from other countries that China has the potential to accelerate growth of vehicle ownership. As a rule of thumb, we know that as countries grow wealthier (measured by GDP per capita), vehicle ownership generally rises. Between $10,000 and $20,000, however, the relationship exhibits discontinuity and the rate of motor vehicle ownership increases markedly.

Vehicles and GDP per Capita (2010 Data, China Highlighted in Red)

Source: World Bank, Morningstar

Right now, China has fewer vehicles than we would expect from a country at its wealth level. The country has lagged the expected level of vehicles for countries in its income range for years and could play catch-up in upcoming years. There is the risk that the Chinese government could directly intervene to suppress vehicle ownership growth to limit resource consumption, which would invalidate this relationship. If market forces are allowed to prevail, however, we expect this relationship to hold.

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We think China is entering a period of accelerated motor vehicle ownership, which underpins our analysis for forward-looking oil consumption expectations. We believe crossing over the $10,000 GDP per capita threshold will provide a strong tailwind to gasoline and diesel demand and therefore oil consumption, even at a slower pace of economic growth.

Our Analysis Suggests Chinese Oil Demand Growth of 6%
Our analysis is less an explicit forecast and more a set of factors to frame oil consumption in a lower-GDP-growth China, illustrated quantitatively by the figures we have provided. Our model does not consider an initial period in which investment activity begins to fall. Even in the smoothest of transitions, falling investment activity would reduce employment directly related to investment and cause a ripple effect through associated service industries, resulting in lower household consumption for a period. The temporary effect would certainly be lower oil consumption growth, especially if households defer motor vehicle purchases.

Our initial forecast scenario for oil consumption is a bottom-up analysis, wherein we model refinery throughput growth of 6% annually, about 1% above the average growth rate of the past five years and in line with Chinese news sources reporting anticipated annual growth between 6% and 7%. We then consider additional consumption not captured in refinery throughput, which we assume will grow slightly slower, at 5% annually. The sum of these two forms our base country-level consumption forecast, which we expect will grow on average at just under 6% per year from 2013 to 2017.

Second, we consider oil consumption from a top-down perspective. We categorize oil and refined goods consumption by sector (agriculture, mining, manufacturing, construction, utilities, transportation, wholesale and retail trades, and households) from 2000 to 2010 and compare annual growth rates with those of consumption, investment (or gross capital formation), and government spending captured in GDP to calculate their respective oil intensity factors.

We then consider two scenarios: status quo and rebalancing. In our status quo scenario, we assume gross capital formation growth stays in line with the recent past at about 13%, and private consumption growth averages 6%. We also assume that there is no change in the intensity of oil consumption. We expect oil demand associated with households grows at the same rate as the consumption portion of GDP growth, while oil demand associated with investment activity grows at half the rate of the gross capital formation portion of GDP growth.

In our rebalancing scenario, we assume household consumption growth increases to 7.5%, while investment growth falls to 2% annually. We also consider whether the intensity of oil demand increases as household consumption growth increases. Such an analysis is educated guesswork at best; the state-provided statistics are fraught with inconsistencies, and data from other sources are only marginally better. To build out a scenario, however, we deemed it necessary to assign some figure to a change in oil intensity and examined vehicle ownership in China as a basis for making an assumption.

We think China could see a dramatic pickup in vehicle ownership over the next decade, as it passes into the per capita income range of $10,000-$20,000, even if GDP growth is lower than in the recent past. International data support this, but the actual level of vehicle ownership growth that will be realized is anyone's guess. For the purpose of our analysis, we think it is reasonable to say that vehicle sales will, at a minimum, maintain the current pace of 20% annual growth, even if GDP growth falls owing to lower gross capital formation. Based on this, we also assume that the intensity of oil consumption will be 20% above the rate of the consumption portion of GDP growth (that is, if the household consumption portion of GDP grows at 7.5%, oil consumption attributable to households will grow 20% higher, at 9%).

For simplicity, we assume government spending will grow 8% in both scenarios and there is no change to oil intensity. Net exports are not broken out in our analysis, as we believe they are captured under transportation in China's oil consumption statistics.

Putting it all together, we find that if China follows the path of our status quo scenario, favoring investment over consumption and postponing rebalancing, our top-down forecast resembles our bottom-up analysis. Oil consumption growth would lag overall GDP growth, at about 6% per year.

More interestingly, we find that in a rebalancing scenario in which investment growth slows significantly but consumption grows at a moderately higher rate than in recent years, the increased intensity of oil consumption counterbalances the slowdown of investment activity, and oil consumption still grows at approximately 6% per year.

Compared with the five-year historical average of 6.3% growth, we expect that oil consumption will continue to grow at an average pace of about 6%. We reiterate that in the short run, consumption could vary from the forecast we've laid out, and our analysis is better used to frame mid- to long-term expectations.

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Finally, we note that our assumptions and conclusions vary from economic forecasts performed by the Chinese themselves. China National Petroleum Corporation put out a presentation at the end of 2012 that suggested the opposite of our findings, including assumptions of 7%-9% GDP growth through 2030 and slowing vehicle possession because of limited resources and urban traffic capacity. However, CNPC did not support its claim with any data in the presentation. We think the argument is easily countered with the reports of Chinese ghost cities and their empty roads. Furthermore, the extensive construction of Chinese expressways, which now exceeds that of the United States in total kilometers, currently supports far fewer vehicles and contradicts the assumption that the Chinese are not planning on an acceleration in vehicle ownership. CNPC also suggested that gasoline demand will grow much more slowly than vehicle possession owing to higher fuel efficiency, among other factors. Again, we disagree, and point readers to the Jevons paradox, which states that as the efficiency of resource consumption improves, the rate of consumption of the resource increases.

CNPC concludes that China's oil demand will grow at an annual rate of 3.1% in 2010-20, far below our 6% forecast. We do not see this as likely, unless the government directly intervenes to limit the purchase of new vehicles and the consumption of gasoline. An alternative explanation could be that CNPC is simply trying to adhere to China's objectives in the latest five-year plan, and this estimate may not actually carry much weight.

China's Domestic Oil Production Outlook
CNPC stated in a December 2012 presentation that China will depend on domestic sources for oil products by 2020, while imports will "support seasonal and type regulation." We have little confidence that China can depend on domestic supply to satisfy the majority of consumption, given a lack of growth from maturing fields, limited exploration additions to reserves, and a negative outlook for the prospects of unconventional production.

China's domestic oil supply comes mostly from a collection of mature oilfields, producing just under 4.2 million barrels per day in 2012. Over the past 54 years, more than 14 billion barrels of oil have been produced from Daqing, which provides roughly 20% of the country's oil production; as of 2012, PetroChina reported that the field still contained 4.8 billion barrels of proved developed and undeveloped reserves. Operations at Daqing are carefully managed to maintain steady production levels. According to CNPC, the field produced about 1 mmboe/d for 27 consecutive years before output was reduced in 2003 to a target of about 800 mboe/d, a level it has held steady for nine years.

Many oilfields are so old that they have long been subjected to enhanced oil recovery techniques in an effort to sustain production levels. This has dramatically increased the cost of production, including at Daqing. At some point, we expect that no level of spending will maintain stable output, causing field declines to sharply cut into production levels at the national level.

What's more, China is not adding to proved reserves through exploration at a rate sufficient to accommodate a sustained period of production growth. China's reserve life did improve in 2010, we assume because of higher oil prices used in the U.S. Energy Information Administration's calculation of proved reserves. However, the reserve life indexes for each of the individual national oil companies (PetroChina, Sinopec, and CNOOC) fell in 2010.

A final constraint to increasing domestic oil production is the possible deliberate deferred development of new oilfield discoveries to augment China's strategic petroleum reserve. The country targets SPR volume of 90 days of supply by 2020, through a combination of government and commercial enterprise controlled stocks. To the best of our knowledge, all storage facilities are currently above ground, but there has been suggestion that forgoing development of strategically located oilfields could be a tactic of increasing the barrels available to China's SPR.

We have constructed a country-level supply forecast by examining the historical production levels for the national oil companies and comparing them with the reported production levels of their respective parent state-owned enterprises, as well as the EIA's reported country-level oil production statistics. From there we have extrapolated a forward-looking supply forecast by grossing up our aggregate NOC forecasts to the SOE level and adjusting for additional production not captured at the NOC or SOE level (based on historical figures). According to our forecast, we think China's domestic production will grow 2% annually over the next five years.

Prospects for Unconventional Oil and Gas Look Dim
Government leaders and the oil companies in China seem to hope that unconventional oil or gas development will meaningfully boost domestic production levels and reserves. A recent study published by the EIA listed China as possessing the highest level of technically recoverable shale gas reserves and third-highest level of shale oil reserves in the world. Successfully exploitation of these shale formations would allow China to add proved reserves while continuing to increase production levels.

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However, there are a number of reasons unconventional development will be severely difficult. First is the depositional environment of many of China's shale basins. Prehistoric organic material settled into different types of waterbed to become source rock, and the type of waterbed it settled in makes a big difference today in the relative ease with which these structures can be drilled horizontally and the efficacy of hydraulic fracturing. In the U.S., many of the major shale plays originated as marine depositional environments--high-energy formations that wash out smaller grains and particles. In contrast, many of the shale formations in China are lacustrine environments--low-energy, shallow lake beds where smaller grains and particles are not washed away.

Those small grains and particles found in lacustrine deposits generally form shale that is much higher in clay content than shale in marine depositional environments. Clay is the enemy of horizontal drilling and hydraulic fracturing; it causes wellbore integrity to be unstable and fissures from the fracking process to collapse, prematurely choking off well output and the ultimate recovery of hydrocarbons.

An additional challenge is that many of China's shale formations contain heavy folding and faulting, which can cause dual complications. First, it is difficult to drill the horizontal leg of the well to a desired length and still hit enough of the target pay zone to achieve decent production rates. Second, faults form as a result of seismic activity, and an earthquake could shift the faults and effectively shear off a portion of the well's horizontal length.

Tectonic activity in a nonfaulted portion of a formation can also ruin a well. The extreme pressure from seismic forces can cause fractures to flatten and can constrict well output.

Finally, there is the issue of water availability. China's water supply has become increasingly constrained as growing urban populations and irrigation for agriculture draw higher amounts of groundwater and deplete aquifers. Assuming China were to drill and frack wells at the same pace as North America, we calculate the incremental increase in water consumed to be about as much as an additional 2 million-3 million people annually. This may not seem large in a country with a population of more than a billion, but it is a strain on available resources, especially since the water used must be disposed of, instead of returned to the water supply.

China has sought to develop unconventional production, but so far has failed to make progress anywhere near the level of the United States and Canada. In fact, there were 4 times as many horizontal oil and gas wells drilled in Texas in 2011 as there were in China.

China is often portrayed as lacking the technological capabilities to build an economically successful and repeatable unconventional development campaign. This may be so, although PetroChina, Sinopec, and CNOOC have partnered with Shell, Total, BP, EOG, and Hess in China, formed joint venture development partnerships with Encana, Devon, and Chesapeake in North America, and purchased Nexen. Considering this access to so many partners with unconventional experience and operating in an industry where we have yet to see a sustainable competitive advantage originating from proprietary technology, we think China's geology-specific challenges are far more likely to blame for lagging North America. As such, a quick ramp-up of unconventional oil production or gas is a tremendous long shot, in our opinion.