Thursday, May 04, 2006

Zero Sum or Nonzero Sum Market?

I followed a link on MSN Money with the catchy title, "Worldwide Oil Race: China vs. US." It took me to this article on "How China is winning the oil race." Sobering stuff, if you take it at face value. Who can deny that China is scouring the world to lock in contracts for the raw materials necessary to continue its economic growth, with energy at the top of the list? However, it's unnecessarily paranoid to see this economic competition as one the US is fated to lose because of our principles, resulting in Chinese companies snatching irreplaceable barrels out from under our SUVs. That would only be true in a static marketplace.

The key fallacy in the author's argument is that oil supply is a zero sum game. That's wrong, unless everything that has characterized this industry in the past has changed in the last two years--or unless Peak Oil is here, now. While it is correct that oil tied up on long term contracts with China will not be available to other countries for years, if ever, Mr. Markman weakens his own case by pointing out the degree to which many of China's new suppliers are countries with which US and European firms won't deal. Arguably, if China weren't there as an eager, undiscerning buyer and investor, Sudan's oil would not be developed until its regime met international standards on human rights. So these volumes, at least, are additive to a market in which all oil is ultimately fungible.

Consider another example closer to home. Enbridge, the Canadian pipeline company, is considering building a new pipeline to the West Coast, along with a new export facility to send syncrude from Canada's booming oilsands projects to China. One might object that this is oil that ought to come to the US, to back out our imports from less reliable regions. However, there is some point beyond which Canadian oil investors may not wish to rely on a single market, however close. In the long run, some of the oil that would flow to China via this route would otherwise not be produced at all, because there would be no attractive home for it in a saturated US market.

The biggest risk I see for us from China's oil strategy--other than the pressure their demand puts on prices--is more subtle. It relates to a common practice within the energy industry that is unreported outside it. The crude diet of a typical American refinery, particularly a coastal refinery with direct access to international crude, is quite dynamic. It changes day by day and almost minute by minute, in response to changing market relationships between the prices of different grades of crude oil, and the prices of the resulting petroleum products. A cargo bought for refinery X this morning may be resold this afternoon and delivered halfway around the world, instead, depending on market shifts. This practice sounds inefficient but is precisely the opposite, allowing refineries to respond rapidly to small or large changes in demand among the different grades of gasoline, jet fuel and diesel fuel, and to shifts in crude oil availability.

But if key types of crude oil that have historically swung from the US to Europe and back, as markets fluctuated, were tied up by a buyer interested only in channeling gross barrels to its home market, then some of that responsiveness could disappear, and the result would be higher and more persistent spikes in the prices of the petroleum products consumers buy. This would be especially tricky if the barrels in question came from a source close to the US Gulf Coast refining concentration. Venezuela comes to mind, here.

Overall, Americans benefit if China opens up sources of oil supply that we wouldn't touch, because it reduces their call on the suppliers we will deal with, and puts downward pressure on global prices. But if they disrupt the international system of oil cargo trading, then this could add one more constraint on an already tightly squeezed US refinery system. Although that would harm US consumers, it would harm Chinese interests nearly as much, by foregoing opportunities to better the economics of their long-term oil supplies. The best outcome is for China to become as sophisticated in its trading practices as the international majors and financial players, thus adding to the liquidity of the market, even as they grow the pie.

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