China syndrome

Buttonwood

Jun 28th 2005
From The Economist Global Agenda

This time the price of oil is refusing to subside gracefully. If there really is a new paradigm out there, the Chinese are ahead of the pack in realising it

IT FEELS disturbingly like one of those computer games that Buttonwood is fighting a losing battle against in her teen-aged house. Up pops the oil price in autumn 2004, then—POW!—down it goes. Up again in early 2005 and—BAM!—back down. And now, yet again, it is climbing.
In recent days the price of West Texas Intermediate crude for August delivery has been brushing $60 a barrel, settling on Monday June 27th at half a dollar above that level, a record high. The contract fell back the following day but kept $60 in its sights.

The surprise is not that the price of oil is rising. It has been doing so, broadly speaking, for a year. World economic growth ripped along last year at around 5%, its highest level in three decades, and this year, though slower, may see 4%. Fast-growing China is taking roughly one-third of the accompanying increase in oil consumption, but demand is growing in America, the world’s biggest energy guzzler, too. Production has kept pace with demand, but only just, and many worry that there may not be much more in the tank.

The surprise is rather that it took share prices so long to fall in response. In the month from May 22nd, oil prices rose by 21% yet the S&P 500 went up by 2.1%—a respectable clip. When oil first touched $60 it knocked share prices back a bit for three days, but they resumed their climb thereafter. True, some of that gain is accounted for by oil companies and their suppliers, who are suddenly being touted as a buy all over town. But what about other sectors?

Economists argue about the effect of dearer oil on growth. Does it provoke inflation, or recession, or both? How big a price rise does it take to provoke anything at all in these supposedly more energy-efficient days? But no one, to Buttonwood’s knowledge, believes that higher oil prices are a net plus for economic activity. So why aren’t share prices generally feeling more pain?

One theory is that both shares and oil have been rising in response to common factors: buoyant economic growth and profits, and low interest rates. Ben Jacobsen, a finance professor at Massey University in New Zealand, has another theory: it takes investors (like economists) a while to work out the impact of oil-price movements on the economy generally.

Using data from 1973 for developed countries, and a shorter series for developing ones, Mr Jacobsen and his colleagues found that oil-price changes and stockmarket returns are linked but lagged: if oil prices rise, shares do fall, but not right away. Shares of obviously energy-related firms adjust at once, but broad stockmarket returns fall only during the following month or even two months—a pattern that is clearest with biggish oil increases and in countries that are most dependent on energy. This, if true, suggests a genuine market inefficiency.

On that model, expect shares to fall next month—or at least fail to make the gains they would otherwise have made. The bigger question, though, is where both oil and share prices are headed after that.

Oil bulls argue that the price of the black stuff can only go up and stay up. Supply and demand are finely balanced at roughly 85m barrels per day (bpd); extra productive capacity to cope with emergencies is no more than 1.5m bpd, principally in Saudi Arabia, and even that is suspect. The election last week of a hardline anti-capitalist as Iran’s new president has added to fears of a disruption in supply. Discoveries have been tailing off for years and refining is one big bottleneck.

Low oil prices in the late 1990s are one reason why companies did not invest more in exploration and production. Petter Osmundsen, a petroleum economist who teaches at Stavanger University in Norway, suggests another: excessive focus on short-term measures of financial performance, which discouraged firms from making long-term bets on growth and encouraged them to dish out their profits to shareholders instead in the form of increased dividends and share buybacks. Now oil companies, both private and state-owned, are investing hand over fist, but it will be years before anyone sees the benefit.

Unsurprisingly, perhaps, a lot of what thinks of itself as the smart money is on oil prices to rise. Since the beginning of June, the net bullish positions of non-commercial investors have risen sharply, according to America’s Commodity Futures Trading Commission. Their 20,000 outstanding contracts (at last count) are nothing like a record, but they do indicate which way the wind is blowing.

Oil bears, conversely, see demand for oil slowing as economic growth slows, especially in China (whose imports dropped slightly in the first five months of this year, says Andy Xie of Morgan Stanley). And alternative sources of oil—Canada’s tar sands, Africa’s deepwater reserves—are nearer than many think: Cambridge Energy Research Associates, a think-tank, predicts that these and other developments will provide some 6m-7.5m bpd more capacity than the world needs by the end of the decade. All this means that the price of oil is set to drop, the bears growl. But they are an endangered species these days.

Buying security

Against this background a significant drama is being played out: the $18.5 billion bid by CNOOC, a Chinese state-controlled company, for Unocal, an American oil company. It is not the first time that the Chinese have bought abroad to ensure access to commodities, nor the first time that a Chinese enterprise has bid for an American one. But coming at a time when the price and availability of energy are looking a tad dubious, the bid has provoked an outcry in the land of the free.

What is overlooked in the general xenophobia is that China already plays a big part in bankrolling spendthrift America. Thanks to its trade surplus, it now owns several hundred billion dollars-worth of US government and agency debt. Bond yields are low, the yuan is more likely to rise against the dollar than fall, and China is engaged in a dash for economic growth. Is it any wonder that it wants to buy an oil company which, even if bought at a premium, is likely to return more than 4% a year in a dwindling currency, and might improve Chinese energy security in the bargain?

The trouble is that if China makes a habit of snapping up vulnerable American companies, it might decide to buy fewer Treasuries—and that could cause trouble. Alan Greenspan is likely to have this point in mind along with the likely impact of higher oil prices on a slowing economy when the Federal Reserve meets later this week to decide whether to keep raising interest rates. Now, that is a conundrum.

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