Part 3 of The China Syndrome explores the implications of China's activities on the Asian region.

Asia: The Intangibles Of High Oil Prices

December 10, 2004
Crude Moves In Asia

Asian oil consumers are quietly forming an alliance whose goal is to reduce the price of oil being levied on them by Middle East producers.

Reports of OPEC coming together on a production cut surfaced on 12-9 and 12-10. As we pointed out here on 12-9, the cartel would like to keep prices at or above $40 in order to keep profits as high as possible for as long a period as possible. According to Reuters: �Ministers gathering for Friday's conference said there was consensus to withdraw around one million barrels daily of surplus production over an existing target and meet again in February to discuss further cuts.�

What is emerging is a picture of a potential conflict between OPEC, its profit motives, and the effects of prolonged high oil prices, as the International Energy Agency has forecast a slowing in both demand for oil, and in global economic growth. Reuters reported: �World oil demand growth in 2005 will slow from a 28-year high this year in part because a squeeze on fuel supplies for Chinese power generation should ease.� At the same time �the IEA shaved its estimate for 2005 demand growth by 70,000 barrels a day to 1.38 million bpd on the 83.7 million bpd world market. That would put growth in 2005 at 1.7 percent, down from 3.3 percent or 2.63 million bpd this year when China led the steepest increase in world oil demand since 1976.�

The Asian Intangibles

The rate of growth in the demand for oil seems to have slowed in China. According to Reuters, quoting IEA data: �Chinese demand growth in 2005 is forecast at 360,000 bpd, 5.7 percent, down from this year's explosive 14.7 percent or 810,000 bpd, when fuel consumption raced ahead of economic growth, said the IEA, adviser on energy to industrialized nations. The report estimated Chinese third quarter oil consumption slowed as expected to 8.6 percent after gains of 19 percent and 25 percent in the first and second quarters of 2004.�

Yet, even though the rate of growth has likely slowed, and may do so in the future, there is still a larger demand in Asia, than there has been in the past, setting up a potential future conflict.

According to Dow Jones Newswires: �Executives from five South Korean refiners �were- due in Beijing on Thursday for talks with counterparts from major Chinese oil companies on the possibility of jointly purchasing Middle East crude oil.� And while no one expected a major deal to be struck, it was seen as an important beginning. Indeed, the article described the meeting as � more of a preliminary discussion about cooperating in purchasing, and perhaps also in oil stockpiling and oil transportation, than a negotiating session.�

The initial event, seems to have been an attention getter as it sends �out a signal to Middle East crude suppliers that Asian customers aren't happy with current purchasing arrangements, and that they want to find ways of deflating ballooning oil import bills. �

And, why not? This region of the world is starting to get some serious energy consumption clout. According to Dow Jones: �East Asia is a key driver of global oil demand, containing the world's second-, third- and seventh-largest oil consumers. China now needs 5.98 million barrels a day to fuel its economy, Japan's demand is 5.45 million b/d and South Korea's is 2.30 million b/d, data by British oil major BP PLC (BP) show. Asia as a whole now imports more than two-thirds of its daily oil needs of some 23 million b/d, with slightly more than 12 million b/d of this coming from the Mideast.�

Victims Of Their Own Success

There is a circular interdependence to this relationship, and it presents the potential for problems in the future. According to Dow Jones: �The bulk of the crude oil imported by China, Japan and South Korea is bought under annual term contracts negotiated with the supply countries' governments or national oil companies. Asian buyers have long complained that the lack of alternative suppliers and the pricing formula adopted by Saudi Arabia and other Mid-Eastern producers usually discriminates against them.�

There is some inequality in the system though. �Middle East producers regularly offer larger discounts to their customers in Europe and the U.S. when setting their monthly official selling prices, than they do to customers in Asia. So Asian importers usually pay an ["Asian Premium"] of free-on-board flat prices of at least $1.50 a barrel more than their counterparts in Europe or the U.S.� Dow Jones notes, that �in recent months, due in part to shifting price differentials between the various crudes that the suppliers base their pricing on, U.S. customers have been paying more than Asian buyers for their oil.�

But here is the bottleneck, and the source of friction. �Asian nations' demand for crude continues to soar, outpacing local oil output. Accordingly, their reliance on Mideast crude has risen, as have the potential negative economic consequences stemming from their exposure to the Asian Premium. This has prompted them to look for alternative oil sources and also for ways to decrease their import bill.�

The second part of the equation, and perhaps the most touchy, is the currency aspect. �Japan and South Korea are in the comfortable position of seeing their currencies strengthen against the dollar - the currency used to price oil imports - and their import costs are not as high as they might be as a result. But for China, the weaker dollar seen in the past few months hasn't helped to constrain its oil import bill, as it pegs the Yuan to the dollar.�

This is another reason for China to feel pressured, as its currency peg is continuing to be a double edged sword. On one hand, it keeps the engines of its economy flowing, by allowing its products to undercut most others heading into the U.S. and the rest of the world. But at the same time, the yuan has lost some of its purchasing power, making the fuel of the boom more expensive.

Conclusion

Dow Jones concludes that little will come of this, beyond some basic arrangements based on convenience: �there is little prospect that China and its Asian neighbors will agree any time soon on joint purchasing, on a stock-sharing system to help each other in times of supply disruption, or going even further than that by building jointly-managed reserves.�

Here are some overriding reasons:

1) �Officials from China and India, both of which are embarking a massive stockpiling ventures, have made it clear that their reserves will be used to offset eventual domestic oil shortages and not in some Asian pooling system.�

2) �China seems very likely to lose out to Japan's financing muscle in the struggle over the routing of an export pipeline for Siberian crude oil,� and is not on the most friendly of terms with Japan, as it is �locked in heated sovereignty disputes with Japan, and also with several Southeast Asian nations over offshore oil and gas reserves in the East China Sea and around the Spratly Islands.�

3)� Beijing and Seoul may fail in efforts to persuade Russia to build a gas pipeline from Siberia through China and on to South Korea. Russia now seems to favor routing this alongside the crude pipeline, to its Pacific coast, from where the oil and gas can be shipped to Japan and elsewhere.

Bottom line: this is a touch and go situation fraught with significant problems, on multiple levels. But, it does point out that the oil demand from Asia, even if it eventually slows due to an economic event, or even a natural pause in the rate of expansion, is unlikely to return to levels seen prior to 9/11.

That alone, should keep oil prices from falling as far as they would have otherwise, when the eventual production glut appears somewhere down the road.

December 13, 2004
Japan�s Seismic Shift And Its Global Implications

Japan is steadily returning to the ranks of nations with a military whose function is beyond defense of their homeland. And one of the major reasons, as cited by the country�s official policy is the increased global presence of China. This creates a whole new layer of potential friction in Asia, where North Korea, China, and Russian influences are still significant, and where much remains unresolved on multiple levels.

According to Japan Today.com: �Japan's naming Friday of China for the first time as a defense concern in its new defense policy outline poses the danger of intensifying bilateral tensions and may even lead to a vicious cycle of further military buildup in the region. The announcement of exempting sales of missile defense arms components to the United States from Japan's arms export control policy the same day may also unleash an arms race in East Asia if not carefully managed, political experts said.�

To be sure, public disclosures from Japanese officials, point to some disagreements in the subtleties of the new policy. �Defense Agency Director General Yoshinori Ono was specific about Japan's security concerns over China, citing ["the recent case where a Chinese submarine intruded into Japanese waters"] when he called for attention to China's modernization of its military and expansion of naval activities in a statement issued Friday on the new outline. But other key government officials rushed to the defense of the outline Friday and denied that Japan views China as a threat. "It's not that Japan sees China as a threat," Chief Cabinet Secretary Hiroyuki Hosoda said in a news conference shortly after the Cabinet approved the new National Defense Program Outline, which prescribes Japan's defense policies for the next 10 years.�

But, no matter how much officials on either side of the debate try to soften the blow, Japan�s policy toward its military has taken a significant turn. According to Stratfor.com: The Japanese government identified China and North Korea as "grave factors of insecurity" and said taking "positive measures" toward international security would be a major role for the Japan Self Defense Forces (JSDF). The policy's wording is an announcement that Japan will assume a place as a major regional power that will take action when it perceives a threat.�

Stratfor, going beyond mainstream reports added a few layers of analysis, that bring home this point even more effectively.

The intelligence service noted �What also is significant is everything else that occurred on the day the new policy became official. Other events of Dec. 10 that were not especially noteworthy by themselves took on new significance against the backdrop of Japanese remilitarization.� Stratfor was referring to this item: �A Chinese ["survey"] vessel was spotted in waters near Okinotorishima Island, which Japan contends is its exclusive economic zone -- a claim Beijing disputes. The Japanese government immediately lodged a protest with China.�

In effect, China was already testing the new Japanese policy, and is likely to lead to a more rapid implementation of the new policy in Japan, as well as potentially produce more similar events, as both countries begin to play a dangerous cat and mouse game.

Stratfor also notes that popular opinion surveys in Japan are showing increasing support for a more military posture by the Japanese government, particularly against China and North Korea.

Also interesting is Stratfor�s report of the fact that �Japan's new stance also is causing concern among its regional ["allies."] South Korean President Roh Moo Hyun already has expressed dissatisfaction with Tokyo over a change in Japanese attitude and response to contingencies on the Korean peninsula. The South Koreans are worried that Japan's new policy, which Pyongyang will certainly view as aggressive, could provoke North Korea into withdrawing further from any constructive dialogue over its nuclear program.�

The Dance Of Death

This is a complex situation with the potential for large amounts of trouble if the right spark appears.

According to Japan Today.com: �China is East Asia's military giant in terms of military spending, ranking third in the world in 2003 at $55.95 billion, and its official defense budget in 2004 registered double-digit growth for the 15th year. In comparison, Japan's defense expenditures totaled $42.84 billion in 2003, which ranked second in Asia and fifth in the world, according to the latest Military Balance publication. Japan benefits from its strong security alliance with the United States, the world's sole superpower that topped the list with overwhelming military spending of $404.92 billion in 2003.�

Japan made more important moves last week, as it �announced in a statement issued Friday by Chief Cabinet Secretary Hosoda that sales of missile defense components to the United States will be exempt from the arms export ban.� Japan Today.com noted: �Japan's desire for a missile defense system is inevitable, given that North Korea lobbed a ballistic missile across the Japanese archipelago in 1998. But Japan's cooperation with the United States in missile defense has already provoked strong reaction from North Korea, whose state-run media criticized Japan on Tuesday as ["intensifying regional conditions to extremes"] and that Pyongyang ["would definitely not just stand and watch Japan become a military power."]

Bad Timing For China

Most important here is the situation in China, economically. The China Aviation Oil (Singapore) situation has quietly faded from the news. But it is by no means gone. An investigation is ongoing. And the company has been given extra time to put forth a reorganization plan.

There are other signs, though, that the Chinese economy is at a crucial fork in the road. According to U.K. Intelligence pros at Jane�s.com, there have been major disturbances, and signs of social disobedience in China of late, with the inciting cause being the uneven distribution of wealth that has resulted from the ongoing, and albeit fading economic boom.

Jane�s, in its Foreign Report, dated November 24, noted: �By all accounts (China) is enjoying a boom but there are clear signs that the economy is running into trouble. Protests and disorders are spreading in urban factories and through the rural community. In October, sociologist Lu Xueyi wrote in the China Daily of the social inequalities operating in the country and warned: ["China is at the crossroads. It can either smoothly evolve into a medium-level developed country or it can slide into stagnation and chaos."]

The report, citing Chinese sources, concludes that �the latest public order disturbances are just the tip of the iceberg of social unrest that may lie in the path of the nation's long-running economic boom, which has served to highlight an increasing social inequality in China. According to the Communist Party magazine Outlook, there were more than 58,000 demonstrations throughout China last year, or around 160 a day, and these protests are becoming ever more serious,� including some demonstrations where protestors numbered over 100,000, and where martial law had to be imposed, while requiring as many as 20,000 police in order to restore order.

Conclusion

The world has been focused on the Middle East, Russia, Europe, and the U.S. To be sure, these are important variables in an increasingly difficult global situation.

But, in our opinion, Asia�s time, as a major focus, is just around the corner. Japan�s return to an offensive military posture, although couched in nuance, is an important development. That the United States is involved makes it more of a lighting rod move, as China, North Korea, and South Korea are likely to become increasingly concerned, and hot under the collar.

Russia is also in that neighborhood, and to some degree so is India, another important emerging economic power with nuclear weapons.

Each of these players has an aggressive regional agenda, with longer term global ambitions. Each of these players knows that for now, the United States is still the one super power. But each of them is steadily attempting to assure itself as much regional control as possible, both for its own power, as well as to keep the United States out of its back yard.

Japan has chosen to get closer to the U.S., making it a very hot button for geopolitical activity in the near future.

Editor's note: The above reports appeared on www.joe-duarte.com and www.intelligentforecasts.com

© 2005 Joe Duarte, M.D.
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Joe Duarte, M.D.

Joe Duarte M.D. is founder and Editor in Chief of Joe-Duarte.com. Dr. Duarte is a board certified anesthesiologist, a registered investment advisor, and President of River Willow Capital Management, where he manages individual client accounts. His latest books "Successful Energy Sector Investing" and "Successful Biotech Investing" (Prima/Random House) are available on line at amazon.com, barnesandnoble.com, borders.com, Traders Press, and all major online and brick and mortar bookstores in the U.S., U.K. Europe, and Australia.

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