In a fungible global energy market, China does not “need” the United States, nor does the United States necessarily “need” China. America’s oil and natural gas producers can find willing buyers elsewhere and China has no shortage of options when it comes to foreign suppliers. But both countries would benefit immensely from the end of the current escalating trade war.
The economic, geopolitical and strategic advantages of continuing free and fair trade are evident for both countries, which is why both sides should acknowledge the harm that could from this unfortunate episode if it is allowed to continue into the new year.
As the CEO of one of the largest privately owned oil services companies, the trade war has impacted my firm, Canary, LLC. Our total year-to-date spending on items manufactured in China exceeds $10 million. Although many of the vendors we deal with are in Houston, the lion’s share of the manufacturing happens in China through overseas subsidiaries from which we purchase either directly or indirectly. We have scores of Chinese vendors; however, there are a strategic few with whom we have spent $1 million or more over the years.
The trade war is so far not crippling the energy sectors of either country, but the Trump administration’s protectionist trade policies have had real impacts. U.S. tariffs on imports have added 25% to the cost of steel for Canary. That number is no small issue. Steel is a fundamental raw material for everything we do at Canary; it is necessary to make the wellhead and pressure control equipment, valves and other apparatus need by producers in America’s booming shale regions.
Material costs are up more than 8% from a year ago in the U.S. oil sector, which has still not fully recovered from the price collapse of 2014.
Currency exchange risk meanwhile is a double-edged sword with the potential to affect costs by 5% to 15%, and is often a forgotten expense in coverage of escalating trade tensions.
The service sector, including Canary, has had a hard time keeping up with the increase in production. Our sector’s capacity to find and hire qualified workers is nearly maxed out, even though companies are running all out three shifts a day. Supply chain uncertainty can also lead to delays in operations like forging, casting and welding, and makes planning operations and investments extremely difficult.
These are some of the micro issues that have surfaced for energy companies in the United States since tariffs began. But it’s not until you examine the macro side of the U.S.-China energy relationship that you begin to understand the scope of opportunities that the world’s two largest economies are putting at risk.
No emerging market is more critical to the global oil industry than China, the world’s most significant driver of demand growth. The United States had been making sizable inroads into China’s oil and gas markets before the trade war. That progress is now at risk.
The United States is the world’s largest oil and gas producer, with oil production of 11 million barrels a day and natural gas output of 94 billion cubic feet per day. We have also established ourselves as a major energy exporter. With production forecast to grow further, every incremental barrel of oil and most gas molecules will need to find a home in markets abroad.
Overseas markets have never been more important for the U.S. oil and gas sector, and China is undeniably the most critical market in the world for energy exporters. China last year usurped America as the world’s largest importer of oil. China is not a market where U.S. producers want to be excluded. Annualized at a price of $80 per barrel, Chinese imports of U.S. crude of roughly 500,000 barrels a day equate to $14.6 billion in trade. A U.S. president seeking to reduce America’s trade deficit with China would do well to keep that in mind.
Beijing, of course, has not yet slapped tariffs on U.S. crude oil imports. That remains an arrow in its quiver as trade talks continue. But it has taken action against natural gas, hitting American liquefied natural gas, or LNG, with a 10% surcharge, which effectively makes U.S. gas uncompetitive in China.
China’s natural gas markets are arguably more valuable than its crude markets for aspiring exporters. In 2017, Bloomberg Intelligence estimated the United States exported 1.5 million tons of LNG to China at a value of about $644 million.
But the opportunity is so much more significant of U.S. gas exporters. China was the third biggest market for U.S. LNG in 2017, right behind South Korea and Mexico. China has become the world’s fastest-growing LNG market after imports surged by nearly 50% last year to nearly 40 million tons. The trend of rapid growth has continued this year as the Chinese LNG market has expanded by a further 50%. China’s growth is expected to drive global LNG demand for the next decade, as China tries to improve its air quality by switching from coal-fired power production to natural gas.
An expected “second wave” of U.S. LNG export projects under consideration is turning out to be more of a gentle ripple, in no small part because of President Trump’s approach to trade policy. Costs are everything in the ultra-competitive global energy markets, and for America’s LNG developers more expensive steel is a negative. For U.S. LNG exporters, tack on the 10% tariff applied by China, and that market is out of reach.
The upshot is that banks and other lenders are thinking twice before providing loans to LNG developers. These financiers require LNG exporters to have committed buyers before providing the billions of dollars needed to build export facilities. With the window closing on China, banks are looking for projects in Western Canada, Australia or East Africa, but not the United States.
For China, the potential loss of U.S. energy supplies also comes with negative consequences. It is no secret that China has struggled to sustain its domestic oil and gas production in recent years despite the central government’s best efforts. China’s state-run oil and gas companies have been active over the past decade in global merger and acquisition markets, acquiring upstream assets around the world to compensate for weak prospects at home. But China officials concede their country will continue to rely on energy imports to fuel economic growth for the foreseeable future. Beijing would like to accomplish this on the best economic terms possible – and without relying too heavily on one country or region to reduce geopolitical risks.
China can turn to alternative suppliers for LNG, but it may not be in the country’s best interests to double down on other top exporters like Qatar. Russia is another option, both for piped gas and LNG shipments, but Beijing need only look at Europe to see the pitfalls of over-dependence on Moscow.
Supply diversity is the best strategy for China. Removing the world’s top oil and gas producer from the mix makes little sense. Besides the geopolitical comfort that comes from dealing with a stable supplier like the United States, China can also use the U.S. supply option as leverage with other suppliers to ensure it gets the best price.
Building a closer energy relationship with the United States, including taking advantage of America’s advanced production technology, could also help China stimulate its own energy sector.
It’s clear that Washington and Beijing do not want a trade war, but neither side is likely to push away from the table first. The brinkmanship has markets spooked, as evidenced by the recent sell-off in global equity markets.
The International Monetary Fund recently noted that the two economies at the center of the ongoing tariff fight will see slower economic growth in 2019. The Fund maintained that the United States and China would grow by 2.9 percent and 6.6 percent, respectively, this year but said both would slow more than expected to 2.5 percent and 6.2 percent, respectively, in 2019.
That economic impact extends to energy markets where experts now see global oil demand growing at a slower pace than expected this year and next. The Paris-based International Energy Agency recently cited U.S.-China trade tensions when it lowered its oil demand growth forecasts for 2018 and 2019 by 110,000 barrels a day to 1.3 million barrels a day and 1.4 million barrels a day, respectively.
Oil prices have fallen in lockstep with benchmark Brent under $80 a barrel, even as the market faces the elimination of Iran’s oil exports from renewed sanctions. Iran sanctions and supply fears had previously put oil prices on boil and, perhaps, headed toward $100 a barrel. That is no longer the case. It takes a substantial event to reverse such market psychology, but fading U.S.-China trade hopes qualify.
With both sides now looking to dig in for the long haul, markets will get worse before they get better. And without a more pragmatic approach in Washington and Beijing, the energy industry is in for a bumpy ride.