China shale hopes hinge on reform

The factors that enabled the US shale energy boom stand in sharp contrast to the fetters of the statist model

PUBLISHED : Monday, 28 April, 2014, 9:50am
UPDATED : Tuesday, 29 April, 2014, 1:11am

Expanding energy production in the United States could change the world. It may have, already - American inaction in Ukraine and Syria could be partly the result of less dependence on energy imports causing less interest in world affairs.

The US energy revival is driven by domestic production from shale that displaces oil imports. China also has a good deal of shale.

To see if China can duplicate America's energy path, we need to know why the US is so far ahead in shale production, with others looking to copy.

"Better technology" is not a good answer. In the integrated global energy market, vital technology should not develop so much faster in one country.

The factors driving US energy development are: first, perhaps the world's deepest property rights to land; second, free entry and exit into the energy industry; and third, a genuinely commercial financial system.

Beijing would have to abandon its longstanding love of national champions

On all three, China falls well short, at least for now.

The US is one of very few countries where ordinary citizens can own not only land but the associated resources as well. This can greatly speed development of the resources by freeing the process from political disputes.

Second, it was not Exxon or Chevron that made the shale breakthrough - the global oil majors lag well behind. Rather, it was smaller private firms. These firms faced few anti-competitive barriers, such as government-owned giants sheltered by law or politics.

Finally, US finance has well-known problems, but the country still boasts by far the biggest private securities markets in the world with which to support innovation.

The three factors necessary for shale success require tight limits on government intervention in the economy. This is why China scores so low.

Chinese reform started in the late 1970s with the granting of limited land rights to farmers, but despite loud talk, there has been little progress since. Farmers still cannot own land, much less the resources embedded in it.

China's energy industry is dominated by state firms and subject to attempts to consolidate it further by forcing out the remaining small participants.

The financial system is also overwhelmingly state-owned and follows policy demands before commercial needs. Thus it is no surprise that - despite the mainland's extensive shale reserves, gigantic energy enterprises, high priority on limiting energy dependence, and a supposedly "get things done" policy environment - China's efforts to exploit its shale resources have failed to date. The China energy story perfectly captures the flaws of the state-led economic model.

The government wants a better-performing energy sector, it has clear ideas for how to accomplish this, and it has almost complete power to implement its ideas.

What could go wrong? Answer: China's energy industry could perform miserably in terms of import dependence, ecology, innovation and efficiency, and be left hoping that relatively small private firms in other countries bail it out.

It would change China and the world for the Communist Party to embark on a course of authentic financial, land and - especially - energy sector reform. Some of this was promised at last autumn's party plenum, but the obstacles are daunting.

Financial reform will take many years to complete, requiring not only privatisation of the bulk of financial assets but a policy environment that encourages risky lending.

The land reform component is more important and even harder, as the party was founded on collective ownership of land. The notion of collective ownership can be modified, and there are pledges to do so. However, achieving US-level land ownership rights is almost inconceivable at present.

Energy sector reform is perhaps most promising, at least in principle. Price controls must be removed, though, not merely adjusted. More dramatically, Beijing would have to abandon its long-standing love of national champions and break up the state energy monopoly.

While a state presence in energy could certainly remain, the key step is free entry and exit into the sector, undeterred by anticompetitive regulation or monopolistic predators.

This shift must go far beyond the current objective of introducing more players into energy only if they co-operate with the state giants.

A much more open energy market, additional private rights to land and an improving financial system are major challenges to achieve, but not impossible ones. If they can be met, China would jump forward in the shale race, reversing the trend towards greater energy dependence.

And if China were to successfully follow in the footsteps of the US, it would have profound implications for both the global price of energy and the power of large energy exporters such as Russia and Saudi Arabia.

It would fundamentally alter the strategic role of shipping and rail lines heading out of the Middle East, giving China far more flexibility. It would alter the disputes over the South China and East China seas.

Or Beijing could retain its statist approach and see its energy industry continue to be outclassed in performance by little American shale companies operating in fully commercial land and financial markets.

Derek Scissors is a resident scholar at the American Enterprise Institute