Chinese bear trap
Oil demand is in for another good year, but gas will be the standout. And the country's oil majors are coming back to the market
For China bears who predicted faltering economic growth and slower growth in energy demand, 2017 showed yet again how dangerous it is to underestimate the strength of the country's economy. Last year turned out to be a much stronger one than many expected, which was a boon for almost all commodities. Whether that represents a newfound stability or yet another counter-cycle on China's path to slower growth is the key question on the mind of most investors going into 2018.
While Opec disappointed oil markets in 2017, demand did not. Global demand estimates were revised up significantly to 1.6m barrels a day. Much of this was down to China, which accounted for almost one third of the increment. China remains firmly in the grip of SUV mania, a trend underpinned by relatively cheap oil prices. Despite headlines around the unstoppable rise of electric vehicles (EVs), the reality is that Chinese consumers want to drive larger cars and SUVs, which are less fuel efficient. With the auto fleet expected to double from 160m to 335m by 2025, there is still a decade of growth ahead for Chinese oil demand.
But while low prices have been positive for demand, they have proved crippling for domestic production. China's two largest oilfields Daqing and Shengli are over 50 years old. With high production costs and breakeven prices of $60 a barrel, onshore oil majors have been forced to cut back on output. Chinese oil production dropped around 4% in 2017 and has fallen by almost 20% from the peak in 2013.
As demand rises and production falls, imports are surging. China overtook the US as the world's largest oil importer in 2017. For the Saudis, it is clear why China has become the most important long-term relationship.
In 2018, we expect demand to moderate and production to stabilise, which will result in slower import growth. With oil prices likely to be capped by US shale, we expect pricing to remain in a "goldilocks range"—neither too hot nor too cold—which will be supportive of demand. But there are risks. We are currently enjoying the third-longest economic expansion in US postwar history. At some point, this will end. It is also not inconceivable that there could be a credit event in China that derails growth, although nothing seems imminent. The other risk to demand is EV growth. While China has not yet announced a date for the ending of the combustion engine (unlike the UK or France), it has specified that 30% of sales must come from EVs by 2025. This could mean that gasoline sales peak around the middle of the next decade.
With the auto fleet to double by 2025, there's still a decade of growth ahead for Chinese oil demand
While oil has been good, gas has been glorious. Although a new "golden age of gas" has felt a long time coming, 2017 proved to be a watershed year. After several years of tepid consumption growth, natural gas demand is growing again at 15% a year. While some of this has been triggered by stronger industrial growth, the real catalyst has been environmental policy. For regular travellers to Beijing, China's pollution problems are well known. Reducing smog in Chinese cities is without doubt one of the top priorities for the Xi Jinping administration.
At the recent party congress meetings in Beijing, Xi pledged to build a "beautiful environment". This means that the transition from high-carbon to low-carbon fuels will accelerate. This year, subsidies have been put in place across northern China to support the large-scale conversion of coal boilers to natural gas. Over the next 10 years, the government intends to increase the number of people connected to the gas grid from 290m to 0.550bn. The National Development and Reform Commission, the powerful economic planning agency, wants to raise natural gas in the energy mix from 6% to 15% by 2030, which would treble demand. In short, the outlook for gas is burning as bright as ever.
While the perception is of a global glut of gas, resurgent Chinese demand growth may lead to the cycle turning more quickly than some expect. We believe that China will have to sign more gas-supply contracts to meet demand needs sooner rather than later. Competition from suppliers will be intense. Russian, Central Asian and global liquefied natural gas producers are all targeting China. Who will win? While economics will play a role in what China decides to do, so too will geopolitics.
Probably the biggest question is whether China will be a major buyer of energy from America. Energy is one way to tip the $300bn annual trade imbalance between the US and China, a priority for President Donald Trump. With an endless list of LNG projects in the US, China could be the catalyst for the next wave of projects. And 2018 is likely to be the year in which things become much clearer.
Reform of state-owned energy companies is also likely to be an important feature of 2018. After several years of disappointment, it looks likely reform will accelerate as the new leadership team takes shape and starts to make decisions.
What will they do? On oil, we expect further reform on pricing, with China taking the final-step towards completely liberalising gasoline and diesel prices. In the upstream, expect more private capital as the government seeks to boost production. In refining, we expect the government will take further steps to rationalise the capacity of independent refineries. Over the past few years, independent refineries have expanded capacity and utilisation rates significantly in response to liberalised crude-import policies. As a result, China has become a significant product exporter. While some worry that independent refiners could expand further, we expect consolidation in the industry as the government seeks to reduce capacity as part of its efforts to curb pollution. Assuming oil prices stay range bound, this should mean that downstream margins continue to be strong in 2018.
In gas, expect further moves towards market liberalisation as the government looks to reduce gas prices. In some ways, the big question for 2018 is whether China will formally split gas pipelines from upstream producers. Or put another way, a break-up of PetroChina, which dominates both domestic gas production and the national pipeline network. To create a more competitive market, the most obvious reform is to create a state-owned gas pipeline company. This would help to establish a unified, open-access pipeline network in China which doesn't exist today. Already, with some of the smaller gas-distribution companies seeking to import LNG independently of PetroChina, 2018 will be a key test of whether market liberalisation is on the right track—or not.
20%—Decline in China's oil output since 2013
In capital markets, the trillion-dollar Aramco IPO will continue to dominate the headlines in 2018. But China will also have its major IPO, namely the listing of 10% of Sinopec's fuel marketing arm. With over 20,000 petrol stations and a valuation of up to $50bn, Sinopec has the largest fuels-marketing network in the world. Most western oil and gas companies have already divested their fuels-marketing networks. Sinopec's decision to spin off its unit is an example of positive reform.
Finally, there is deal-making. It has been almost four years since the collapse in oil prices. Chinese oil majors responded with heavy capex cuts, and free cash flow has never been stronger. As a result, balance sheets have been deleveraged and China's majors have significant cash resources. With reserves on the decline, we expect Chinese oil majors could return to mergers and acquisitions in 2018. While oil sands may not be in demand this time round, LNG and conventional oil assets will be. We expect more state-to-state deals, with Brazil and Russia being likely destinations. Mid-sized European producers could also be targets. If oil prices start to recover in 2019, the timing could be attractive. After several years of M&A being in the doldrums, 2018 could be the year Chinese dealmakers return to the market.
Neil Beveridge is Senior Oil and Gas Analyst at Sanford C Bernstein
This article is part of Outlook 2018, our annual book looking at energy market trends for the year ahead. To purchase a copy, click here