China’s economic slowdown has been having a major impact on oil and commodity prices over the past year. As a result, oil prices are returning to historical levels (around $30/barrel), as the chart shows.
China’s $15 trillion stimulus program had been one of the main reasons for oil prices returning to the $100/barrel level after the financial crisis of 2008. It fed the illusion that the country had suddenly become middle-class overnight, with US standards of living. Essentially, it created what one might call “subprime on steroids” in China’s property sector, causing average home prices in the Tier 1 cities to reach 14 times regular earnings. This was around double the peak of the US subprime bubble.
The parallels don’t stop there. As in the US, many Chinese spent some of their windfall gains on buying a new car, which caused auto sales to surge 50% in 2009 and by a third in 2010. As a result, China’s imports of commodities such as oil, copper, iron ore and even polymers soared. But it was all just a bubble. Average Chinese income levels simply couldn’t support this level of demand once new President Xi began to turn off the lending tap after taking office in March 2013. Even in the affluent urban areas, incomes are only around $4000/year, and just $1500/year in the rural areas.
Slowly but surely, reality is now bursting the commodities’ bubble, just as it has been bursting China’s stock market bubble over the summer. As a result, a vast and growing over-supply now exists of most commodities. Oil prices have already halved over the past year and they probably have further to fall, as supply continues to expand at “breakneck speed” according to the International Energy Agency. Oil production is still profitable for US producers at today’s prices – for example, ExxonMobil’s average US cost last year was just $12.72/barrel. Plus, of course, Iran is about to return to the market as a major seller, now that the nuclear agreement has been finalized. And this at a time when oil inventories are already at record levels all around the world, including in the US.
This return to historical levels is very bad news for the US petrochemical industry, which is currently planning to spend around $145 billion on export-focused investment. The reason is that most of this new capacity was based on the assumption that oil would always stay at the $100/barrel level, giving US shale gas-based producers a major cost advantage versus most foreign competitors. Oil has a higher energy value than gas, and has historically traded at around 10 times natural gas prices. So $30/barrel oil would completely erode the shale gas advantage, assuming gas prices remain around $3/MMBtu.
Clearly, companies will now have to re-examine the economics of all these projects in the light of China’s economic slowdown and the oil price collapse. This will inevitably be a very painful process, particularly where construction has already begun. But in this case, it will be the lesser of two evils. The alternative, having to operate loss-making plants for years to come, would be too awful to contemplate.
Paul Hodges is chairman of International eChem (www.iec.eu.com), trusted advisers to the chemical industry and its investment community. He is a member of the World Economic Forum’s Industrial Council on chemicals, advanced materials and biotechnology, and presents the ACS ‘Chemistry & the Economy’ webinars.