A word on the link between China and oil

Up to this point, readers would be forgiven for thinking that I hold China free of any responsibility regarding the current slowdown in global economic activity, but that is not correct. China’s problems are just very different and have little to do with falling commodity prices. It is faced with a decapitated banking industry, which has been far too willing to lend to all kinds of investment projects – good and bad. At the same time, the Chinese growth model has been driven by investments and exports, whereas the growth in consumer spending has been relatively modest.

A few numbers to support that statement: As recently as 10 years ago, exports and investments constituted 34% and 42% respectively of Chinese GDP, i.e. less than a 1⁄4 of Chinese GDP came from the combination of consumer spending and government spending. By comparison, consumer spending accounts for over 70% of U.S. GDP.

By 2014, investments had grown to 46% of GDP, whilst exports had fallen to 23%. The further growth in investments has been funded by rapid credit expansion in China’s banking industry, which has grown from $3 trillion in 2006 to $34 trillion in 2015 (source: Hayman Capital Management, February 2016). That is a shocking amount of credit in a $10 trillion economy.

Now, the Chinese leadership face a big challenge. They must restructure the banking industry whilst at the same time seek to change the growth model. I can think of quite a few things that can go wrong in that process. Having said that, China is a user of commodities, not a producer and stand to benefit from lower commodity prices.

Informed sources tell me that Chinese GDP is growing at 3-4% per annum at present – not at 6-7% as claimed by official sources, but neither at 1-2%, as some pessimists have suggested more recently. The slowdown in Chinese economic growth is to a large degree down to the problems in the banking industry that I alluded to above. Non-performing loans are rising at no more than 1-2% if you believe official numbers, but the true growth rate in non-performing loans is more like 5-10%, or so I have been told.

The economic slowdown in China has certainly had some impact on oil prices, but one shouldn’t overstate China’s role in setting the price of oil. After all, China ‘only’ accounts for 16% of global GDP, and we have been through economic slowdowns of a magnitude similar to that of China before, without it having had the same dramatic impact on oil prices. I can only conclude that the steep fall in oil prices appear to be a supply problem, and have little to do with economic problems in China.

One additional point. Oil is widely known to be a very inelastic commodity, which explains precisely why oil prices have fallen as much as they have. A relatively modest slowdown in economic activity – not only in China but across the world – combined with higher than expected supplies, has created an imbalance between supply and demand, and the price has behaved exactly like the textbook prescribes.

So what precisely does the textbook say? Chart 7a provides a graphical illustration of the effect on price, should demand for a ‘normal’ commodity change modestly. In chart 7b you can see the effect the same level of demand change has on price, assuming that both supply and demand are inelastic. Not surprisingly, the price move is much more dramatic.

However, before you conclude that, in the current environment, oil prices can only go one way, and that is further down, let me share with you an observation that was pointed out to me recently (source: Frank Veneroso, January 2016). Monthly crude oil production numbers suggest that U.S. oil production has fallen nearly 400,000 barrels per day more than what the weekly numbers have suggested – and which nearly everyone follows – implying that the global oil market surplus is less than most estimates, and is likely to fall fast as the year progresses.