A New World Order
Source: Joel Hanley, The Barrel (2/28/11)
"History is being made with Asia's rise in the oil markets."
There was a time, long before the European explorers set sail to find the New World, that the East held all the cards. Indeed up until its period of introspection under the Ming rule in the 15th century, China was the day's only true superpower, with an economic and military strength to rival any other. Now China is back stronger than ever and, along with other Asian countries, challenging the long-established norms of the European oil markets. Since 2003 almost every analyst report and financial column has seemed to cite China as the key demand center and global industrial hub, the true engine of economic growth at a time when the rest of the world has seemed to flounder in the global economic crisis of 2008 and its aftermath.
This industrial drive from the East, particularly from China, has changed the way the oil business works, creating a counter-intuitive shift that has led Europe, a continent with hundreds of thousands of barrels per day in spare refining capacity, to buy refined products from thousands of miles away.
This directional change has turned market logic on its head, according to Leo Drollas, deputy executive director and chief economist at the Centre for Global Energy Studies in London, a think-tank founded by former Saudi oil minister Zaki Yamani. "In terms of the world's efficiency of operation, this is not the right thing to do—we are going backwards," he says. "We are going against the internal logic of the markets of moving crude oil to the demand centers."
There are several reasons for this but at the heart lies the somewhat bleak refining picture in Europe. It would be too easy to say that Eastern influence has in some way overpowered the European refining world by flooding the region with cheap products that it can make and transport with economies of scale some nations can only dream of. What is more realistic is that European refining has long been a business ripe for consolidation, with ageing equipment, finding it hard to make a good margin, especially in the lower demand environment seen since 2008.
One of the main issues with the European refinery profile is the age and lack of complexity of its plants. With many refineries lacking the kind of upgrading required to make the most of barely profitable refining margins, many of the simpler facilities have closed down to be turned into storage terminals, as Petroplus' Teesside plant in northeast England did in 2009.
While these and other likely closures might bring some balance to the Western oil refining picture, there is a school of thought that says even more will close as they cannot compete with the big plants in the Middle East that could pick up the slack.
"Refineries are being shut in the West and, because demand has not risen at the old rate, there is still quite a lot of surplus capacity—perhaps up to 3 million b/d in the West so there will be more closures," says Drollas. Such terminals—and indeed more successful refineries—are now an attractive buy for Asian companies looking to take a foothold away from home. PetroChina last month bought a stake in petrochemicals major Ineos' European refineries, while India's Essar Energy remains interested in Shell's UK Stanlow plant. But Drollas sounds a note of caution for potential Asian buyers. "They think they can make the refineries work better and that might be the case but I think they will get a surprise. The problem is that demand isn't there," he says. "The question is whether the existing refineries in the West are enough to cater for the demand coming from the West itself."
Refining overcapacity is not solely a European issue, however. Parts of Asia, while booming, have patches of surplus supply, creating product that still needs to find a home, as Japan, South Korea and Singapore all have output that puts pressure on local markets. Added to this, China's refinery building and upgrading, and also the low prices on its internal market, will lead to ever more exports, Drollas feels.
"We will have more of the same. The Far East will continue to have surplus oil product which they will move around," he says. "They're building so much capacity in China, the Gulf and in India that exports will inevitably come to the West." Analysts and traders often cite Reliance's gargantuan 1.24 million b/d Jamnagar oil refining complex in western India as being a very obvious part of Eastern demand and one that is big enough to change the way that oil moves in some regions.
Leo Drollas sees this move to larger refineries with better economics as a further threat to the European refining industry.
"A lot of these new refineries are larger, only with smaller costs, and that's going to lead to more exports too. Much of that will head west," he says. But while Europe may be reeling from Asia's refining surge, the United States is not. Nearby Caribbean refineries can compensate for any lack of capacity in the US refining sector. And, in any case, the distance from Asia to the Eastern seaboard of the US is simply too big to make economic sense.
The Impact of Espo
The US Pacific Coast, however, has been one beneficiary of a key result of the oil world's shift eastwards. At an estimated cost of more than $20 billion, Russia's 5,000 km Eastern Siberia-Pacific Ocean (ESPO) pipeline has opened a direct route to China from the Siberian oil fields, reducing Russia's export reliance away from the Baltic and Black Sea.
With huge natural resources and easy geographical access into many other Asian markets via its eastern frontier, Russia is towards the top of the list of countries best placed to exploit the booming Asian markets.
Russia's energy strategy has planned for a 25% share of oil exports moving to Asia by 2030, an ambition to which ESPO, with a slated capacity of 1.5 million b/d by 2015, is a major boost. Some 4% of the 600,000 b/d of crude piped via ESPO currently goes to the US West Coast, and this figure is set to rise. But it is China that will gain most, securing 15 million tons of crude a year, or 300,000 b/d, from the pipeline and ensuring a healthy stream into Daqing.
This expansion of Russia's export options is likely to have some implications for its traditional exports of Urals crude to Northwest Europe and the Mediterranean. These implications have yet to be explored fully, but the diversion of some of these export volumes away from the traditional export routes to Primorsk and Novorossiisk should have some price impact.
One thing is certain, though: Increased demand from Asia and the economies of scale afforded by large, upgraded refineries have already had an effect on the price spread between different types of crude oil.
Traditionally, heavier crude oil has tended to trade at a significant discount to the lighter grades more likely to yield the light-end products, such as gasoline, so keenly sought by Western demand centers. But while a downturn in gasoline demand since 2008 has put some pressure on the prices of the lighter, low-sulfur crude oil often used to make it, the surge in demand from India and China has hugely boosted the value of heavy crudes as fewer cost considerations have come into play. In crude export terms, the big winner in this has been West Africa, and in particular Angola. Nigeria's light sweet crude has long been a favorite of Mediterranean, Northwest European and US Gulf refiners, yielding as it does plenty of light ends. But crude from fellow OPEC member Angola has seen the biggest rise in value from the Eastern boom, as its heavier, sweet crude oil has seen a relative rise versus the lighter grades of Nigeria or even the North Sea.
As West African crude exports to China and India have increased, Asian companies have been beefing up their trading desks in Europe. Chinese firms have been building up their office presence in London, recruiting experienced oil traders and marketers from US, Norwegian and British companies to help source grades from Europe, the Mediterranean and Africa.
The popularity of the African grades has made the region the true swing supplier of choice for the US, Europe and Asia, although in time only Russia and the Middle East will have sufficient reserves and output capability to provide higher production when needed. Much of this future Russian and Middle Eastern supply will move to Asia, according to Singapore- based energy consultancy FGE. "In 2015 to 2020, market dynamics will transform flows to an East-East trade, with the Middle East and former Soviet Union the only suppliers with notable incremental production," the company said in a 2010 report. "Asia continues to be the demand engine," it concluded.
Reversing the Flow
Interestingly, there have been recurring rumors of a direction reversal on one of the major pipelines supplying the Mediterranean from the Middle East. The Sumed pipeline carries oil from the Middle East to Europe across Egypt. In fact, there are two Sumed pipelines, each with capacity of 1.2 million b/d. It has been reported that Sumed is considering reversing the flow of one of the lines to carry crude from Sidi Kerir on the Mediterranean to Ain Sukhna on the Red Sea. Such a move might also be seen as an important political development in the Middle East, given Egypt's partners in the ownership of Sumed. A reversal in the pipeline could indicate an important development from fellow Sumed investors from Saudi Arabia, Abu Dhabi, Kuwait and Qatar and reveal a strategic shift towards Asia by some of the world's largest oil producers.
A decision to reverse the flow of crude through one of the Sumed lines would move Asia-bound crude traffic away from the Suez Canal and open another route for Central Asian, Russian and other Mediterranean crude grades to reach the Red Sea and the growing Asian markets. Such a move would add further weight to the possible future paradigm which sees the East take the crude and the West buy the product.
Now that a sense of a freer economy is well entrenched in China, observers have noticed the increase of more "Western" industrial and social phenomena that could slow things down. There have been signs in recent months that the burgeoning urban population drawn in from the provinces to help drive the industrial growth has started to look a little more disaffected in light of the change in the economy, because even China is not totally immune to the vagaries of the global slowdown.
Workers are increasingly pressing for higher wages, strikes have become more common and there are growing complaints in the country about higher food prices, all of which could lead to a slowdown in growth, Drollas feels.
Any resulting downturn in economic data might, however, be lessened, as he feels that the data released does not tell the whole story. "China is overheating," he says. "Their growth is not as it seems; they overstate their growth because they understate inflation, so their GDP appears to be growing at a faster rate than it really is." This view is supported by a Société Générale report in January suggesting that Chinese inflation is due a break-out from its recent trend.
"The outlook for inflation in China has substantially skewed to the upside. The suspension of disbelief that accompanied a lack of inflation in the context of a closed output gap, above trend growth, extraordinary liquidity growth and a soft and hard commodity dynamic is suspended no more," the report said. Drollas points to another proxy for both consumer and economic growth to back up this argument: electricity demand.
"Electricity consumption, which is a good measure of real GDP growth is not rising at 10%–12%, it's down at 4%–5%. China's long-term growth is a very impressive 5% but not the double digit numbers," says Drollas. Should this indeed be the case then the much vaunted Chinese boom has slowed somewhat - but the effects of its boom are already apparent. China is no longer the sleeping giant that Napoleon Bonaparte would rather stay asleep for fear it shook the world. The giant is up and has already shaken the world.
The nation's emergence as a major economic superpower has changed the nature of business the world over, and not just in oil. But in few industries can this shift in balance, together with the rise of India, Eastern Russia and the continued reserve dominance of the Middle East, be seen as acutely as in the petroleum business. Leo Drollas, for one, is a big believer in the move the oil world has seen. "It's an historic moment as we see the world shift back again to where it all started," he says. "This shift is of real historic significance."