China’s Appetite For Light Crude On The Rise

It appears to be a conundrum worthy of the attention of Fred, Daphne, and Velma (complete with Shaggy and Scooby to solve it), as contrasting signals out of the world’s largest energy consumer has left its impact on oil demand shrouded in mystery.

As China’s economy matures it is a natural process that its energy intensity – exhibited through oil demand – will shrink. This means it will require less energy to produce the same amount of economic growth, due to improving energy efficiencies and a lesser burden from energy-intensive industries. The below chart illustrates that this is exactly what is underway; China added more than double the amount of GDP in 2011 than it did in 2003, yet its oil demand increased by about the same amount (~500,000 barrels per day).

There are two anomalies on the below chart, but both can be explained away; blackouts account for 2004’s high level, when diesel demand ramped up to meet power generation needs. Meanwhile, 2010 was very much a stimulus-inspired response after the belly of the great recession in the prior year. In the years ahead, dots will continue to cluster in the lower right area of the chart:

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While energy intensity may be decreasing, gasoline demand is on the up. Although China is now the largest global car market, with over 23 million cars sold last year (versus 16.5 million in the US), it still has a remarkably low vehicle penetration rate. There are only 7.8 private cars per 100 people, compared to 30 in neighboring South Korea, and a whopping ~70 in the US.

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Despite being a low penetration rate, gasoline demand is on the ascendancy, reaching a record 2.8 million barrels per day in April. While industrial output has been a decent proxy for Chinese oil demand in the past, it would appear that the baton is being passed to the transportation sector.

Peeling off another layer of the onion, we can see that it is SUV sales which are leading the charge in private transportation. As the below chart illustrates, SUV sales now account for 25% of all vehicle sales, up from 15% two years ago. SUV sales through May were up nearly 50% on the prior year.

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Despite these encouraging numbers, both the recent vicious sell-off in Chinese equities and softer economic data are an increasing cause for concern. Indeed, the doubling in the Chinese equity market in the last year has likely been a significant influence on the rise in vehicles sales and gasoline demand, as participation in the stock market rally has left the Chinese people feeling the warmth of the wealth effect.

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But as the equity market has dropped like a falling knife in the last month, we are already seeing cracks appear in the auto sales market. The China Association of Automobile Manufacturers said last week that total vehicle sales may only rise by 3% this year, down from a projection of 7% in January, with the potential of the recent equity market sell-off to further crush consumer sentiment.

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Economic data has also been weak so far this year, although economic growth in the second quarter has managed to stabilize at the government’s target rate of 7%. Retail sales and industrial production also surprised to the upside for June. Rather than spurring a positive reaction in the market, this has stoked more skepticism about the data than anything. The bigger picture is, however, that Chinese economic growth is at its slowest pace in almost a quarter of a century.

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China GDP % YoY (National Bureau of Statistics of China)

This leaves us with a rather curious conundrum. Equity markets have been strong but have sold off recently. Economic data has been weak so far this year, but is showing pockets of strength. Car sales have been stoic, but are starting to show weakness, while gasoline demand has been reaching record levels.

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Turning to what we see in our ClipperData, oil imports into China have been super-strong through the first half of the year – endorsing the strong demand picture painted by gasoline. Imports are up an impressive 12% versus last year, exhibiting improvement in every month.

But it has not only been the volume of oil imports which is interesting, but the change in grades. For China has been ramping up imports of lighter crudes, at the expense of medium and heavy grades. This change in appetite is due in part to the aforementioned rising demand seen for lighter fuels such as gasoline. But it is also due to tighter environmental regulations, as China targets a maximum sulfur content of 10 parts-per-million (ppm) in its gasoline and diesel by the end of 2017.

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(Source: ClipperData)

While some of this rise in imports can be attributed to an effort to boost strategic and commercial inventories, an apparent staunch increase in oil demand cannot be dismissed. But just as rising equities in the first half of the year boosted sentiment, signs of an ongoing fragile economy and a tenuous equity market as we move through the second half of the year will likely lead to a deterioration in mood and a downturn in spending, manifesting itself in both lower oil demand and imports. If only we could blame this on those meddling kids.

By Matt Smith

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