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Editorial
Black Gold
By Dr. Gary K. Busch, 15/10/04
Oct 17, 2004, 09:49




The attention of the world is fixed on the inexorable rise in crude oil prices. The daily news invariably includes some reference to the price of crude oil. The price of crude oil has become a measuring stick of the stability of the world economy and each rise is met with a chorus of doomsayers warning about the effects of further rises. However, this rise in the price of crude oil is only one aspect of the energy crisis and is almost meaningless on its own. There are many factors at play in the energy market, both economic and political, which are important to understanding the rise in crude oil prices and its effect on world development.

There are several starting points. The global demand for oil has been forecast by the International Energy Agency (‘IEA’) as rising to 82.4 million barrels per day (‘mbd’) in 2004. This has meant that there has been a demand growth of almost 5 mbd since 2000.

The growth in demand has not been entirely matched with a growth in supply, even as OPEC has tried to raise its output to stave off higher oil prices. There have been a series of calamities which have impacted prices; the reduction in Iraqi crude supplies; the unrest in Nigeria’s oil-rich Delta; the sabotage of Saudi pipelines and the various hurricanes and typhoons which have damaged refining capacity in the Gulf of Mexico. World oil supply rose by 0.640 mbd to 84.0 mbd in September. Non-OPEC output fell for a third month, by 0.1 mbd. Hurricane Ivan shut-in 0.475 mbd of US Gulf Coast output; similar reductions are expected to persist throughout October. All of these have been cited for their effect on restricting supply of oil into the market.

There are analysts who say that the root of the supply problem is that the crude which is available is of the wrong type. Each crude oil type is different in its characteristics than others. They are all complex hydrocarbon chains, but some are more viscous than others (they are ‘heavier’ or ‘lighter’); some have a higher sulphur content (‘sweet’ crudes have low sulphur); and some have a high waxy content. As oil refining is a process of reduction from crude oil to fuel oil, diesel, gasoline, kerosene naptha, gases and residuals, the type of oil used as the feedstock for this refining and catalytic cracking determines the volumes of output products. Many of the Middle Eastern crudes are heavy and sour, yielding heavier fractions on refining. They produce products in which the ‘bottom end of the barrel’ predominate (fuel oils and diesels). In countries like the U.S., where gasoline and kerosene are prized (especially in warm weather, for auto and airplane consumption) the refining of these crudes does not yield, proportionately, the same supply.

Other analysts say that the speculators are driving the market. They observe that there is no overweening gap between supply and demand and that the markets are roughly in balance, with a downward trend expected. These analysts cite the fact that there are many new reserves of oil found in Equatorial Guinea, offshore Nigeria, Sudan, Sao Tome, Mauritania and Chad, to name but a few, which have yet to be figured into the equation. At these prices even degraded oil structures, like oil sands, become attractive to suppliers. In addition, most of these new crudes are light, sweet crudes, and highly desirable and trade at a premium. These analysts cite the speculators as being responsible for running up the markets for short-term speculative gain.

There are other analysts who look outside the industry to see signs of why oil prices are high and are likely to remain high Approximately 46% of the world's oil production is seaborne. And today, most new oil discoveries occur offshore rather than onshore. As a result, a staggering 80% of all new oil production capacity coming on-stream worldwide relies on oil tankers. By 2011, it is estimated that 95% of all new oil production capacity will use oil tankers. Right now, the oil tanker business is running at close to 100% capacity and, by the end of the fourth quarter of 2004; demand for freight will exceed the capacity to supply. With the turn towards colder weather the shipping of heating oil is driving up the price of product carriers to new highs.

The cost to ship a barrel of crude is about $3.47 to the U.S. and $1.53 to Singapore for Saudi vessels. Using a freight rate of WS 150, owners of double-hulled very large crude carriers can earn about $100,000 a day on the benchmark route to Japan and South Korea, after deducting costs such as fuel and port fees. Earnings are at $83,000 a day for the route to the U.S. One of the largest tanker owners, Frontline's, break-even point was $26,860 a day for its 35 VLCCs so that the profitability of the tanker business is very high. This high freight rate will be sustained, even if the price of crude diminishes. Charter rates for tankers are already exorbitant. They've rocketed more than fivefold during the last two years...but now they're likely to go even higher.

It can be said with great certainty that supply of tankers will not keep up with demand. In December 2003, the International Maritime Organization, an arm of the United Nations, agreed to eliminate single-hull tankers by 2010 and to accelerate the timetable to phase out certain single-hull vessels by May 2005. This means that 13% of the world's tanker fleet will have to be scrapped by April 2005. By 2010, a staggering 40% of the world's oil tanker fleet needs to be replaced. All oil tankers need to have a double-hull to avoid accidents like that of the Prestige or the Exxon Valdez.

The scrapping of a considerable part of the fleet comes at a time when every single tanker in existence is already operating at around 100% capacity utilization. Vessel prices for all ship sizes continue to rise. Contributing factors include high steel prices and lack of available berth space in shipyards as well as owners wanting to purchase vessels to take advantage of high oil demand and a rise in OPEC production. Newbuilding prices on VLCCs are up by $30 million from last year; $14 million for Suezmaxes; $15 million for Aframaxes and $7 million for Panamax vessels. Steel prices have reached $600 per ton; double what they were two years ago. The current price of plate steel in Japan is $700 per ton. The shipping rates for oil seem unlikely to decline.

The enormous rise in the price of steel is a good clue to the source of the problem of high oil prices. The problem is China. China is now the second largest importer of oil in the world; second only to the U.S. China has become increasingly dependent on crude oil imports, with the amount of crude oil imported rising from 31 percent in 2002 to 50 percent in 2007, according to official sources. Research by China's Ministry of Communications on marine oil transportation predicted that the country would import 100 million tons of crude oil in 2005, 150 million tons in 2010 and in 2020 the number would soar to 250 to 300 million.

The more than 6 percent annual growth of China's national economy and the readjustment of the economic structure is behind the country's higher demand for crude oil, but oil production has failed to keep pace with the economic growth and only registered 1.7 percent growth annually. China imports approximately 1.4 million barrels of crude oil per day from the international market. One-third of the growth in global oil demand comes from China. With OPEC reaching its short term production limits, China's rising appetite for oil has helped drive up the world's oil prices.

China's industries consume the majority of its oil, as they help generate phenomenal growth rates. But as increasing numbers of Chinese begin using cars, they are driving up demand for oil even further. In the first quarter of this year, new car sales in China increased by 45 percent. Besides oil, China is pushing global demand for other resources. According to 2003 government figures, China consumes around half the world's production of cement, one-third of its steel, one-fifth of its aluminium and a quarter of its copper. The impact of China on the metals industry is unprecedented. Trade of raw materials, ores and finished metals to China have led to very high prices for metals and rejuvenated the dry cargo shipping business.

In the midst of such a growth cycle, China desperately needs power. China's power shortage problem is much more serious this year than last. Most provinces and cities have put limitations on power usage, even Beijing and Shanghai. The power shortages are also affecting foreign investment. Most of China's thermal power plants are fuelled by coal, not oil. But there are production and distribution problems, and coal reserves have already fallen below normal levels.

Taking a long-term perspective, however, the oil crisis poses a more serious threat, because oil has more applications that are closely related to China's future economy and national defence as well as the Chinese people's livelihood.

Chinese oil imports this year will amount to about 35 percent of domestic oil consumption. Because state-run enterprises make up the bulk of the Chinese economy, they are pervaded by waste and corruption, which together with China's traditional fondness for grandiose projects and short-term profits leads to a massive waste of resources. According to official Chinese figures, resources used for the creation of US$1 of GDP are 4.3 times higher than in the US, 7.7 times higher than in Germany, and 11.5 times higher than in Japan. China consumes 31 percent of global coal resources, 30 percent of iron ore, 27 percent of steel and 40 percent of cement, but that the resulting GDP is less than four percent of global GDP. China's economic growth will therefore consume a frightening amount of oil. If China is to succeed in building a prosperous society it will need to have access to a continuing supply of light, sweet crudes.

Right now, more than 60 percent of China's crude oil is imported from the Middle East, which means security over the long shipping routes is a major strategic issue. China is therefore actively developing "oil diplomacy" to find new sources of crude oil. The first place they turned was to its former "comrade," Russia, which possesses abundant oil deposits and is geographically convenient for the creation of an oil pipeline between the two countries. China's former leader Jiang Zemin ceded some Chinese territory to Russia in exchange for advanced military equipment and oil. The Chinese chose Yukos as its partner and planned for an oil pipeline from Siberia to China.

Russia, however, has been very cautious and clearly also has its own agenda. As a result, it has hindered China's efforts to buy Russian oil companies and rejected the construction of the Angarsk-Daqing oil pipeline. Now, the sheiks of the Kremlin are prosecuting Yukos with an eye to taking its assets back into state control and still refusing to build a pipeline. Putin has promised to increase rail traffic to China for Russian oil; an expensive and time costly development. China is having to look elsewhere (particularly to Kazakhstan). The Russians are determined that China will not get cheap oil.

The U.S. is also not rushing to push down oil prices. Although higher energy costs are damping down the recovery in the U.S., the impact of these increases are likely to be far less than the impact of a booming, unrestrained China, raising prices for metals, grains and other commodities. It is cheaper, and better, for the U.S. to seek additional domestic sources of supply of crude oil; to work with the West African developing oil market to reduce costs and risks, and to expand the use of natural gas by allowing LNG trains to be built in new locations on the Pacific Coast and the Eastern Seaboard.

The U.S. and Russia are agreed on this policy. The high price of crude allows marginal fields to be reopened or, as in the case of Russia, to expand into eastern and northern Siberia, where exploration costs are high. There is a lot of rhetoric about the Russian takeover of Yukos from the U.S. but, in general, if it keeps Chinese energy costs high it is not a matter of great concern.

So, the high price of steel is a better indicator of why oil prices are high than the analysis of supply and demand. There is no other effective way of reining in Chinese growth other than overt hostilities. One can safely look forward to an extended period of oil prices in the $42-$52 band. It can be blamed on Nigeria, Iraqi insurgents, Al Qaeda outrages in Saudi, Venezuelan intransigence or bad weather. The bottom line, however, is Chinese industrialisation and search for energy.