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Between a rock and a hard place

The impact of a changing Chinese energy market on oil prices

Is the high cost of domestic production of one of the world’s largest oil producers creating a new market for the global supply glut and a counter balance to falling US shale extraction costs?

Much has been made of the role of US shale as a quasi-swing producer and with US production already back up 7% since a June 2016 nadir, drilling efficiency currently 40% higher vs 2014 and “fracklog” (measured in Drilled but UnCompleted wells) at record levels the notion of a shale ceiling on oil prices is compelling. Where exactly this ceiling hangs is a debate in itself but with OPEC-led production cuts at 96% compliance (as of May 2017) and the Brent barrel averaging $52 so far this year a $55-60/bbl cap seems about right.

So, with crude seemingly lacking the escape velocity to achieve any meaningful gains over the next 12 months just how low can it go? Our colleagues at WGEG Research would point to some 2.7 million barrels a day of additional supply coming into the market over the 2017/18 period from projects sanctioned during 2012-14. This hangover from $100 oil could well threaten the delicate equilibrium currently at play and test the resolve of non-GCC contributors to OPEC production cuts and if OPEC et al resort to “everyman-for-himself”, what could stop a price free fall?

Enter China. With global liquids consumption at unprecedented levels this is undoubtedly a crisis of supply and even with consensus that demand will grow by a further 1.4 million barrels a day in 2017 it simply won’t be enough to offset anticipated output gains. With the demand side a case of “robust but not robust enough”, it’s easy to dismiss the potential role of China, the world’s second largest consumer and importer of oil, in balancing supply/demand.

However, it is important to remember that China is also a top 5 oil producer – at least until recently. Whilst most very large producers have seen output fall over the past 24 months, the EIA suggests only China is currently producing at lower levels today vs 1Q2014 (US output has already grown by 7% since a June 2016 nadir and Russia/Saudi Arabia were producing at record levels just prior to the OPEC cuts in November 2016). Having already lost around 300kbpd, China has increasingly looked to cheap imports to replace expensive domestic production (average lifting costs are estimated at $40/bbl and as high as $45/bbl at the giant Daqing field) and to fuel the country’s economic growth.

Since 2014, and the liberalization of local legislation allowing smaller, “teapot” refiners to access foreign cargoes, Chinese crude imports have increased by 24%; far outpacing the 10% growth in consumption over the same period. This trend is also having significant international ramifications with China also recently replacing Canada in April to become the largest buyer of US crude exports, currently at around double the levels recorded in 2016.

With low oil prices incentivizing China to reduce production and provide a much-needed relief valve for US & international stockpiles, could we be seeing the emergence of a “bamboo floor” countering the “shale ceiling” and leaving oil prices between a rock and a hard place for the foreseeable future?

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