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Oil.  It Brings Good Things to Life.

On April 4, Abdalla S. El-Badri, OPEC Secretary General, at the OPEC-IEA-IEF Session of the 14th International Oil Summit in Paris, France,  delivered a keynote speech that spoke of oil’s place in world history.  Read the speech here.

We agree.

The Wall Street Journal wrote today how OPEC sees China potentially overtaking the U.S. as the world’s largest oil importer by 2014.  The U.S. independent is having an impact on the world stage.  “With the shale boom in the (U.S.) threatening to drastically reduce America’s oil-import needs, China is expected to take its place in the number one spot,” OPEC said in a report posted on its website this week.

EnerCom published a report to clients in March which addressed China’s oil consumption.

In the wake of establishing diplomatic relations with the United States, China began a slow march away from a centrally-planned economy to free markets. Deng Xiaoping led the reformists in the People’s Republic of China (PRC) and was instrumental in pushing through a 1978 package of economic reforms the new leadership called “Socialism with Chinese characteristics.” That relatively benign phrase belied an economic revolution that would change the face of economics, finance and manufacturing on a global scale.

The chart above plots the growth of Chinese Gross Domestic Product (GDP) from 1960 to 2011 (the most recent year for which data is available) in current U.S. dollars (source: The World Bank).

It was not clear to everyone in 1972 that when Nixon initiated the process to normalize relations with China, which would open the mainland to trade with the West, that what he really did was unleash an economic dragon (China’s national symbol)! At the time, the prevailing expectation was that China’s billion people would serve as a giant untapped market for Western goods, and we all got on board with the vision of American factories producing goods to be sold to the new billion-person market across the Pacific Ocean.

Globalization Turns the Tide of Trade

More than 30 years later, we now know that the export vision did occur, but not in the way that many originally expected. Although the Internet has been around since 1982 when the internet protocol suite was standardized, it did not enter the mass market consciousness until the 1990s. If we were to pick a start time for when mass market adoption of the Internet began, it would be 1996. That was when the nascent America Online (AOL) began charging a flat fee subscription for unlimited access to the web. The coined phrase “You’ve got mail” as AOL users checked their email accounts became part of American culture, and use of the new communications medium by consumers took off.

Corporations were not far behind, as they followed their customers into the cloud. We could not have realized then just how much this new global communications technology would change our world. The Internet was cheap and reliable and rapid improvements turned it into a secure way to share huge amounts of data worldwide at the speed of light. With the new infrastructure, capital and ideas can move across political borders, oceans and continents in seconds. Combined with a robust global transportation and shipping network, the Internet helped stitch together the world’s economies, through a process that we now know as globalization, a trend that dominates all of our discussions on investing, economic policy, monetary policy, technology adoption and law.

Enabled with globalization, trade patterns changed. Instead of American firms exporting goods and services to China, U.S. companies closed factories down in the relatively high-cost United States and built new production facilities in China (and other countries with a labor cost advantage) to take advantage of a low-cost workforce. The cost advantage was enforced by China pegging the value of its currency to the dollar, thus guaranteeing a cost advantage for Chinese goods.

As a result, China became the world’s factory.

Export King

The Chinese economic model was like many other developing countries, based on exports to the developed world. The simplest export model is that of selling raw materials and resources to those who consume them. Oil exporting nations have built a global business model on this approach. However, China did not turn to commodity exports to drive their model. They dove right into manufacturing, building things and selling them at a profit.

The chart above illustrates the rapid growth in U.S. imports from China by month. The difference between the red area (U.S. imports from China) and the blue area (U.S. exports to China) is the U.S.-China trade deficit, shown by the yellow bars (Source: World Trade Organization).

The implication is that from a trade perspective, China has certainly received the lion’s share of the benefits. Of course, U.S. consumers have benefitted from lower-cost goods that help to moderate inflation and stretch a dollar farther. Before the collapse of the Soviet Union, we could also attribute a geopolitical benefit by strengthening their rival.

Today, trade between the U.S. and China is a critical component of our political, economic and financial landscape. Here are some facts about U.S.-China trade relations. According to the Office of the United States Trade Representative (USTR):

  • U.S. goods and services trade with China totaled $539 billion in 2011. Exports totaled $129 billion; Imports totaled $411 billion. The U.S. goods and services trade deficit with China was $282 billion in 2011.
  • China is currently our second largest goods trading partner with $503 billion in total (two ways) goods trade during 2011. Goods exports totaled $104 billion; Goods imports totaled $399 billion. The U.S. goods trade deficit with China was $295 billion in 2011.
  • Trade in services with China (exports and imports) totaled $36 billion in 2011 (preliminary data). Services exports were $25 billion; Services imports were $11 billion. The U.S. services trade surplus with China was $13 billion in 2011.

To put those numbers into focus, the United States is not only China’s top trading partner, but also its primary customer for exports. The chart below ranks the top customers for Chinese exports in 2010 (sources: U.S.-China Business Council and PRC National Bureau of Statistics).

The chart below illustrates what China’s customers are buying. The top categories are manufactured equipment and machinery (source: U.S.-China Business Council and PRC National Bureau of Statistics).

China is not just a source of inexpensive clothing and goods for the American consumer. In many cases, U.S. companies have come to rely on China as a source of vital equipment for generating power, manufacturing goods and providing healthcare.

Money, Like Water, Flows to the Point of Least Resistance

With the United States as China’s best customer, China’s foreign exchange reserves have been building and that capital has flowed back to the U.S. in the form of increasing Treasury bond holdings, making China one of America’s biggest lenders. The relative stability, transparency and liquidity of U.S. financial markets have made U.S. securities and easy buy for foreign investors, including China.

 

At the end of Q2’12, the most recent period for which data is available, foreign and international investors held $5.3 trillion or nearly one-third of the total U.S. public debt of $15.9 trillion at that time. In 1992, the federal debt was $4.1 trillion and foreign holdings were a relatively paltry $550 billion, or 13% of the total.

Becoming the world’s factory, and when we say “world” we mean the United States, has given China a lot of cash that it needs to park somewhere. Domestic demand is not great enough to spend all the funds at home, so China has become a leading buyer of U.S. Treasury debt. In December 2012, the Treasury Department reported that China was the top holder of U.S. public debt at $1.2 trillion.

If not necessarily politically aligned, China and the U.S. are intertwined economically and financially. Critics of China’s holdings of U.S. Treasury debt have often warned of the dire consequences should China ever “call in the debt,” and demand that the federal government pay them back. Although theoretically possible, we are not sure that the architects of one of the greatest economic turnarounds in recent history are going to bankrupt their best customer.

The situation would be ironic, if it was not tragic in some ways. Think of this interpretation. American consumers are buying inexpensive products made by people who put them out of work (actually, the multinational corporations did that, because that is how capitalism works), and a portion of the profits are flowing back in the form of financing the U.S. government, which among other things provides unemployment payments and other social services. Given this interpretation, we are paying for our own food stamps.

It is also ironic that it was capitalism that saved the Chinese communist party. If it weren’t for the 1978 reforms led by Deng Xiaoping, China may have imploded economically and socially like the Soviet Union. For that reason alone, we should consider that even if the Chinese are imperfect like all people, perhaps a bit wiser than most.

Dependence on China’s Export Model – Shifting Geopolitical Realities

We have become accustomed to thinking about the U.S. dependent on China for low-cost goods and financing the federal budget deficit. If we are guilty of economic and political myopia, then we might miss how the U.S.-China trade relationship impacts other players, including the nations that supply the raw materials and resources to keep the factories humming along. Consumerism and globalization has led to a rapidly changing global supply chain and geopolitical landscape.

Bloomberg economist Michael McDonough compiled export data that we believe does a good job illustrating this point. His findings are illustrated in the chart below.

 

There are some obscure countries with hard to pronounce names on that list (lots of “stans”), and changing trade patterns helps explain some of the diplomatic moves China has made over the past decade. Many of the countries on the chart are resource-rich in the raw materials needed to make not just cheap plastic goods, but cell phones, microprocessors and other high-tech devices. Although we might cringe when we see PRC diplomats arrive at an African capitol with suitcases of cash, deep down executives of multinational corporations and policymakers know that they are really securing the raw materials needed to make the iPads, laptop computers and other goods that Americans and others in the first world will buy from Chinese exporters.

Oil Consumption – Sea (See The) Change

Powering an economy growing as fast as China’s is a monumental task, and satisfying the Chinese economy’s fast-growing appetite for energy is a global challenge. Unless the factories are chugging away, the world won’t get the products it wants to buy at a price subsidized by cheap labor.

The chart below plots crude oil imports from 1990 through 2010, the most recent period for which full-year data is available. In 2009 China surpassed Japan as the world’s third largest crude oil importer, while the United States remained the world’s second-best customer for oil behind the EU (but does anyone really consider the EU a “country”). China consumed 4.7 million BOPD in 2010, a whopping 8,196% more than the 58,000 BOPD that nation consumed in 1990. Even more impressive is the compound annual rate of growth for Chinese crude imports at 269%.

Could the day be coming when the U.S. begins exporting oil, or better yet, natural gas back to China? That day may be years or maybe even decades away, but a fundamental shift has occurred in the oil markets while we were all shopping at Wal-Mart. For the first time ever, China is now the world’s largest net importer of crude oil.

One month does not necessarily establish a trend, but this development represents what many expected and presages a fundamental shift in the dynamics of global oil supply and demand. Thanks to increased energy efficiency in factories, homes and autos combined with the aftershocks of the second great depression (20+ million still unemployed and driving less), the U.S. imported 5.98 MMBopd in December 2012, the lowest level since February 1992.

Commodity Prices

For many years the oil markets have factored in growth from the BRIC countries (Brazil, Russia, India and China) as a primary driver of crude oil prices. The chart below plots Chinese net oil imports against Brent oil prices. With a few exceptions, namely the global economic depression in 2008 and 2009, the price of sea borne oil has increased in step with the rise in Chinese oil imports.

 

There was a time when the world’s oil traders maintained a laser focus on the Persian Gulf and the Middle East for supply shocks. However, as the dragon’s thirst for oil continues to grow, we expect that China’s crude oil demand will increasingly become the primary factor setting world oil prices.

It is no secret to people in our industry that the shale revolution has changed everything on the supply side. Thanks to increased energy efficiency, U.S. oil consumption has dropped, but even more importantly American oil imports have fallen because of the rising tide of crude oil production sourced primarily from the emerging shale plays in North Dakota and South Texas.

What the highly prolific Marcellus Shale is to the domestic natural gas industry, America is becoming the “Marcellus Shale” of the world, being the low-cost producer. If we were to extrapolate current trends, the United States could turn from being the world’s biggest consumer to its most stable and reliable energy supplier. Should the U.S. transform itself into an exporter of crude oil and natural gas, it would create many new opportunities in economic, domestic and foreign policies. This transition is underway right now, and the geopolitical impacts are significant. But, that is a theme for another month.

The Industry Moves Forward In Historical Transformation, But Will Feds Snatch Defeat from the Jaws of Victory?

If the U.S. indeed becomes the world’s low-cost producer of energy, then how will the nation use this new trading power?

  • Will there be a temptation to become a “price maker”?
  • Will the disruptive technologies of fracture stimulation, horizontal drilling, 3-D seismic, and deepwater drilling and production drive a new market suite for U.S. industry?
  • Will America become a supplier of energy to China, improving trade imbalances and creating a new economic, security and political paradigm?

Despite all the apparent positives of a strengthening energy sector and rising energy production in the U.S., reducing energy imports, the administration and many citizens still seem in the dark. In our feature story “Production on Federal and Non-Federal Leases – Behind the Political Rhetoric” reported on Oil & Gas 360®, we cited a recent study that finds that recent increases in oil and gas production have occurred in spite of federal action.

On February 28, 2013, a reported titled “U.S. Crude Oil and Natural Gas Production in Federal and Non-Federal Areas” written by Marc Humphries, Specialist in Energy Policy, was published by the Congressional Research Service. We provide a few bullet points sourced from the report for thoughts on the matter. All date ranges sourced are from 2009 to 2012 unless otherwise noted.

  • U.S. crude oil production on non-federal lands increased 31% to 4.6 MMBOPD.
  • U.S. crude oil production on federal lands (both onshore and offshore) decreased 6% to 1.6 MMBOPD.
  • U.S. natural gas production on non-federal lands increased 25% to 55.3 Bcf/d.
  • U.S. natural gas production on federal lands decreased 31% to 10.2 Bcf/d.

Hypothetically, if we apply the 31% growth rate experienced from 2009 to 2012 on non-federal lands to federal land production, and use a 20% royalty for federal offshore production and a 12.5% royalty for federal onshore production, an additional $3.01 billion of revenue from crude oil production would have been generated from federal lands. We used an $82.66 per barrel crude oil price which was the average price during 2009 to 2012.

We’ll close with this statistic: only 24% of the 72.8 million acres of federal acres under lease are producing.

We are blessed to live in a country that supports private enterprise and the ability for non-government controlled companies to grow and prosper on private lands.  We only wish our administration would hop on the bandwagon and streamline the federal permitting process and contribute to the growth – not take away from it. America could benefit mightily.

Important disclosures: The information provided herein is believed to be reliable; however, EnerCom, Inc. makes no representation or warranty as to its completeness or accuracy. EnerCom’s conclusions are based upon information gathered from sources deemed to be reliable. This note is not intended as an offer or solicitation for the purchase or sale of any security or financial instrument of any company mentioned in this note. This note was prepared for general circulation and does not provide investment recommendations specific to individual investors. All readers of the note must make their own investment decisions based upon their specific investment objectives and financial situation utilizing their own financial advisors as they deem necessary. Investors should consider a company’s entire financial and operational structure in making any investment decisions. Past performance of any company discussed in this note should not be taken as an indication or guarantee of future results. EnerCom is a multi-disciplined management consulting services firm that regularly intends to seek business, or currently may be undertaking business, with companies covered on Oil & Gas 360®, and thereby seeks to receive compensation from these companies for its services. In addition, EnerCom, or its principals or employees, may have an economic interest in any of these companies. As a result, readers of EnerCom’s Oil & Gas 360® should be aware that the firm may have a conflict of interest that could affect the objectivity of this note. The company or companies covered in this note did not review the note prior to publication. EnerCom, or its principals or employees, may have an economic interest in any of the companies covered in this report or on Oil & Gas 360®. As a result, readers of EnerCom’s reports or Oil & Gas 360® should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. As of the report date, neither EnerCom nor any of its employees has a financial interest in any equity or debt of any company mentioned in this report.

 


Important disclosures: The information provided herein is believed to be reliable; however, EnerCom, Inc. makes no representation or warranty as to its completeness or accuracy. EnerCom’s conclusions are based upon information gathered from sources deemed to be reliable. This note is not intended as an offer or solicitation for the purchase or sale of any security or financial instrument of any company mentioned in this note. This note was prepared for general circulation and does not provide investment recommendations specific to individual investors. All readers of the note must make their own investment decisions based upon their specific investment objectives and financial situation utilizing their own financial advisors as they deem necessary. Investors should consider a company’s entire financial and operational structure in making any investment decisions. Past performance of any company discussed in this note should not be taken as an indication or guarantee of future results. EnerCom is a multi-disciplined management consulting services firm that regularly intends to seek business, or currently may be undertaking business, with companies covered on Oil & Gas 360®, and thereby seeks to receive compensation from these companies for its services. In addition, EnerCom, or its principals or employees, may have an economic interest in any of these companies. As a result, readers of EnerCom’s Oil & Gas 360® should be aware that the firm may have a conflict of interest that could affect the objectivity of this note. EnerCom, or its principals or employees, may have an economic interest in any of the companies covered in this report or on Oil & Gas 360®. As a result, readers of EnerCom’s reports or Oil & Gas 360® should be aware that the firm may have a conflict of interest that could affect the objectivity of this report.