Time to Rethink Chinese Oil Demand?

With the Chinese economy having slowed considerably, many observers have declared the end of the commodity “super cycle.” It was a cycle driven in large part by China’s steroidal industrialization and energy-intensive growth, which bolstered prices for inputs ranging from iron ore to oil to copper for most of the 2000s.

Another super cycle is unlikely to emerge in the foreseeable future, particularly since China’s growth trajectory took a turn around 2013 and began a secular slide. This was the result of a double whammy: the withdrawal of the enormous economic stimulus program China launched following the global financial crisis, and incoming President Xi Jinping’s pursuit of an economic restructuring agenda that put even more downward pressure on growth.

How China’s economic transition might shake out certainly affects the outlook on global commodities. At a minimum, it is doubtful that China will again become the formidable driver of demand it once was. It was a surprise, then, when economists at the Federal Reserve in San Francisco recently took a rather bullish position, arguing that China would continue to support oil demand and prices, based on their application of the “Varian Rule.”

Figure 1. Chinese Oil Demand Projections through 2025
Source: FRBSF.

The rule, proposed by Hal Varian, Google’s chief economist, stipulates that, “A simple way to forecast the future is to look at what rich people have today; middle-income people will have something equivalent in 10 years, and poor people will have it in an additional decade.” The rule was intended to only apply to the spread of technology goods, such as mobile phones, as they get cheaper.

The Fed economists, however, applied it to predicting future Chinese oil demand. But their projection is essentially a simple extrapolation of oil demand based on how fast the Chinese economy grows. In other words, they posit that a growing economy will create richer Chinese consumers, and those wealthier consumers will use a lot more oil (as was the case in South Korea, which the Fed economists cite as a likely model for China’s oil consumption trajectory).

Putting aside the fact that drawing on South Korea’s historical oil demand isn’t very instructive in determining China’s future—in part because, unlike China, South Korea’s oil demand profile is more determined by industry than transport—the two potential scenarios posited by the Fed economists are based on assumptions that may not come to pass. For one, China is unlikely to average 7% growth through 2025, which forms the foundation of their “high growth” scenario. Even the “low growth” scenario, which is potentially more realistic, omits important factors that I will explain below.

The fundamental problem, however, is that such projections are less useful when significant uncertainty hangs over just how the Chinese economy might change, let alone how fast it might grow. The process of economic adjustment China is currently undergoing could well extend beyond 2025, the entire period the Fed’s projection covers.

But if one were to engage in this forecasting exercise, it would necessitate at least moving away from straight line projections predicated on GDP growth and take into account major countervailing factors. One factor may be structural. That is, China’s economic growth is becoming more efficient in general after a protracted run of inefficient industrialization and resource utilization (see Figure 2).

Figure 2. China’s Economic Output Becoming More Energy Efficient
Source: KKR.

But an even more important factor for the future of oil demand is the transportation sector, which has become the biggest contributor to China’s oil consumption in recent years. Gasoline and diesel, for example, made up over half of China’s crude consumption in 2016. That is, of the 556 million tons of crude consumed, about 282 million tons were refined oil products predominantly used in transport (see Figures 3 & 4). But as the charts show, the consumption of both crude and refined products has waned in recent years, with diesel consumption veering into negative growth in 2016. Some of this could well be attributed to declining economic activity in recent years.

Figure 3. China’s Refined Petroleum Products Consumption (in million tons)

Figure 4. China’s Crude Oil Consumption (in million tons)
Sources: NBS; CNPC.

Hence, it is probably more appropriate to compare China to the United States, where transportation is the biggest driver of oil demand, rather than South Korea. As of 2016, China’s total civilian vehicle fleet (includes passenger vehicles and trucks) was about 194 million, still significantly lower than the roughly 250 million such vehicles on American roads. Of course, its large population virtually guarantees that China will end up with the largest vehicle fleet in the world, even if it remains below the US level in per capita terms.

Yet it is far from clear that China intends to faithfully replicate America’s experience. There are already signs that the Chinese government is aiming to steer the country onto a different path that relies less on oil, and more on electricity and gas, for transportation (see Figures 5 & 6). The choices China makes regarding its vehicle fleet and the types of fuel going into those vehicles could make any of today’s projections of oil demand even more obsolete.

Figure 5. Natural Gas and Electric Vehicles As % of Total

Figure 6. Natural Gas and Electric Vehicles Growth
Sources: CAAM; NBS.

*includes CNGVs and LNGVs; **includes pure EVs and hybrids; ***includes passenger vehicles and some trucks.

Although natural gas vehicles (NGVs) and electric vehicles (EVs) make up merely 3% of the total civilian vehicle stock, their growth has exploded, far outpacing the growth of the overall vehicle market. Over the last six years, the number of NGVs and EVs sold annually has grown on average 32% and 139%, respectively. Such growth won’t be sustained indefinitely, and as I’ve written previously on Two Fen, Beijing is trying to impose some order and control over the EV industry, potentially even cutting production subsidies that could raise prices for consumers.

Still, it is not unreasonable to assume that China’s major urban centers could rapidly adopt EVs and NGVs. One recent case study from Tsinghua University that focuses only on Beijing, a city of 23 million, projects a scenario in which a quarter of the Chinese capital’s vehicle stock could be EVs by 2025. If similar or higher EV penetration rates are seen in other major cities, then it would result in a considerably different picture of Chinese oil demand than the one envisioned by the Fed economists.

Beyond vehicles, China is also rapidly swapping diesel for electricity in its passenger rail system. More than 20,000 km of high-speed rail (HSR) track has been laid, with ambitious expansions underway. By the end of 2016, the HSR system had already completed 1.4 billion passenger/trips. How the electricity-powered HSR system might alter consumer transport preferences remains to be seen, but should not be neglected in the consideration of future oil demand.

Finally, Beijing’s support for electrifying and gasifying the transport sector goes beyond pure economics. Policymakers do not particularly like that the country is dependent on imports for nearly 65% of its oil. In the first few months of 2017, for example, China imported about 9 million barrels/day, surpassing the United States as the world’s largest net importer of oil. Even if China’s vehicle fleet grows more modestly than expected, the import dependency ratio will continue to rise.

The fixation on “energy security” is the non-trivial political rationale behind Chinese government policies aimed at avoiding the path of oil-dependence that the United States has taken. In fact, Chinese academic studies on modeling transport sector scenarios regularly invoke energy security as a justification for more aggressive efforts to adopt NGVs and EVs.

Taken together, these political and industry dynamics make predicting China’s oil demand much more challenging and less assured than has been the case for a long time. Any projection will have to accept a great deal more uncertainty as China embarks on an uneven transition from the old economy to the birth of something new.