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Gavekal Dragonomics

The Future Of China’s Oil Demand (I)

While China’s demand for coal and many other basic commodities has gone into decline over the last year, its consumption of crude oil has continued to climb strongly. According to official figures, oil use grew by a robust 5.7% in 2015, and by 3.1% year-on-year in the first quarter of 2016. This continued growth of crude usage reflects that China’s demand for oil, unlike other commodities, is not driven overwhelmingly by heavy industry and construction; it is also tied to solidly growing demand for a whole spectrum of consumer goods ranging from cars, through furniture, to plastic bags. That growth will help to support China’s oil consumption over the coming years, despite stagnating demand for diesel, the favored fuel of heavy industry. As a result, China’s domestic oil consumption is set to continue rising at an average annual rate of at least 3% between now and the end of the decade, while as a side effect, China’s exports of heavier refined products, especially diesel, are likely to rise significantly.

This projection for future oil consumption is based on my forecasts of how the GDP intensity of different oil products—the amount consumed to generate each unit of output—is likely to develop.  As the composition of China’s economy evolves, shifting away from construction and heavy industry and more towards consumer demand, the diesel intensity of GDP is set to decline, while the gasoline intensity will increase. These forecasts are then applied to different scenarios for overall GDP growth to give actual demand for different oil products under a consensus scenario, which sees output growth falling from around 6.5% YoY this year to 5% in 2020, as well as in bullish and bearish growth cases.

Stagnant diesel demand

Diesel still dominates China’s oil product mix, accounting for 40% of all product demand. In 2015, however, diesel demand stagnated, growing a mere 0.4% YoY. That should not be too surprising, given that much of China’s diesel consumption goes to fuel the heavy equipment used in the mining and construction sectors, as well as the trucks that transport bulk materials. As investment in property, and hence construction activity, slowed through 2015, so did diesel demand growth. A cyclical upturn in real estate investment, driven largely by state sector spending, may support demand in the near term. However, as China’s housing market matures, demand for new residential properties is peaking, and in the long run construction volumes will slow (see Housing’s Next Decade).

As a result, diesel demand growth has decoupled from GDP growth, with China’s diesel intensity of GDP set to continue declining. After falling by
-22% between 2011 and 2015, diesel intensity is likely to fall by a further -19% from 2016 to 2020. In terms of actual consumption, that implies an increase in diesel use between 2016 and 2020 of just 3% under the core scenario, equal to an average annual increase in demand of 0.6%.

Gasoline is a smaller component of China’s oil product mix, at about 25% of the total. But while diesel consumption is flat, gasoline demand is growing strongly. According to the National Development and Reform Commission, gasoline consumption climbed 7% in 2015. Other data sources put the increase even higher, at as much as 9.5% (see the chart above). This rapid growth is widely attributed to China’s robust new car sales, which hit a record 24mn vehicles in 2015. However, it is not new car sales that govern gasoline use, so much as the total car population and driving patterns.

Revved up gasoline sales

Growth in the car population is currently running around 11% behind new sales, as new vehicles replace older ones on the road. In addition, new cars have much more efficient engines than older models, which helps to moderate gasoline demand growth as numbers grow. And as the car population grows, regulations to ease traffic congestion are likely to mean individual cars get driven less. These factors, together with the authorities’  reluctance to cut domestic fuel prices in line with the slump in the international crude price, will partially offset the overall growth in car numbers and the growing preference for bigger cars with larger engines, slowing the growth in gasoline demand. As a result, as the market matures, and the growth rate of the total population of cars eases, the rise in China’s gasoline intensity of GDP should slow.

Following a 12% rise in gasoline intensity between 2011 and 2015, I expect the annual increase to slow over the next couple of years, with gasoline intensity stabilizing from 2018 to 2020. However, that still implies a rapid increase in actual demand, with gasoline consumption climbing 35% between now and the end of the decade under the core scenario, which equates to an average increase of 6% per year.

For other oil products, the picture is mixed. Demand for some, for example jet fuel, has grown strongly in recent years, and is likely to continue doing so on the back of solid consumer demand. However, growth in products with industrial applications, such as heavy lubricants  and petrochemical feedstocks, is weak. Overall, that means the other products intensity of GDP is set to fall by around -10% over the next five years, a similar decline to the one seen over the last five.

In short, a moderate increase in gasoline intensity will drive a strong increase in absolute demand for gasoline over the coming years, while a continued decline in the intensity of diesel and other products will see demand stagnate. Exactly what this picture means for China’s consumption of crude oil depends on how easily China’s refineries can reconfigure their current set-up to cater for the changing domestic demand for different oil products.

Crude intensity

Until now, the configuration of China’s refineries has been dictated by demand for diesel, with refiners producing diesel to gasoline in a ratio of 1.5:1 by weight. The core GDP scenario implies that the demand mix will shift towards a diesel to gasoline ratio of less than 1.2:1 over the next five years. If China’s refiners have the flexibility to vary their product mix in response to changing demand—and in recent years they have successfully reduced their diesel to gasoline ratio from 2.2:1—then the crude oil intensity of GDP will continue to fall in line with total product intensity.

In other words, China’s crude oil intensity of GDP will fall -12% by 2020, or at an average annual rate over the next five years of -2.6%. That implies the growth of China’s demand for crude oil to meet its domestic consumption of oil products will slow to 2% a year by 2020. That equals a decline in annual demand growth from almost 440,000bbl/day this year to less than 260,000bbl/day in five years time.

We can compare this base case with two additional projections: a “bullish” scenario which sees GDP growth stabilizing at 6% YoY, and a “bearish” scenario under which growth falls to 3% in 2018 and stays there. Assuming that GDP intensities of the different oil products follow the same trajectories as in the base case, the bullish scenario would see oil demand growth of 3.5% YoY, while the bearish case suggests demand growth of just 1.4% YoY between now and 2020. In reality, of course, oil product intensities are themselves affected by the growth rate of GDP. So, for example, if overall growth were to slow because of a steep slowdown in investment, then it is likely diesel intensity would also decline, leading to an even more pronounced slowdown in actual demand for diesel.

The history of Japan shows these dynamics at work. In early 1970s, Japan’s housing starts peaked and per capita steel use topped out. As GDP growth stepped down from double to mid-single digit rates, Japan’s oil intensity fell by more than -30%. China today is facing a similar structural slowdown in construction activity. Admittedly, the oil market is in a very different situation: today plentiful supplies have driven down prices; in the early 1970s, prices were pushed sharply higher by the oil crisis. Nonetheless, a -12% decline in China’s oil intensity over the next five years looks probable.

To put this decline in oil intensity into perspective, over the same time period I expect a -21% fall in China’s overall energy intensity of GDP, and a -28% drop in its coal intensity (see Say Goodbye To Coal Imports). The relatively modest decline in oil intensity reflects the shift in China’s economy away from a pronounced reliance on heavy industry—largely powered by coal—and towards a more consumption-driven economy, with a greater emphasis on lighter oil-derived  fuels, such as gasoline. As a result, I expect oil’s share in the overall domestic energy mix to rise by about 2pp to reach 20% in 2020.

However, the actual amount of crude oil consumed by China’s refineries depends on how willing and able refiners are to adjust their product mix to meet evolving demand. As mentioned above, refiners have indeed increased their ratio of gasoline to diesel production over recent years. But, that shift occurred during a period of rapid capacity addition. Reconfiguring existing smaller and less sophisticated “teapot” refineries to favor gasoline production over diesel is unlikely to be so easy. To meet growing demand for gasoline, that means a portion of China’s refinery sector will have to continue refining crude at its present output ratio of diesel to gasoline. The result will be a surplus of diesel compared with domestic demand. There are signs this surplus is already emerging, as China has become a net exporter of diesel since the middle of 2015.

Inflexible teapots

With Beijing reluctant to inflict local economic damage by shutting down relatively inefficient and inflexible teapot refiners, there are two implications. Firstly, that the amounts of crude China refines over the coming years could be greater than the volumes suggested solely by domestic demand for oil products, and secondly that China’s exports of oil products, especially diesel, are set to grow.

Finally, the volume of oil that China imports is dependent not only on the amount it refines, but also by the amount it is able to stockpile: a factor I will examine in more detail in a follow-up report later this week.