China-US relations

China could offer America a trade deal it cannot refuse – on natural gas

Andy Xie proposes a win-win trade between the world’s two largest economies that would – in one fell swoop – spark growth, cut pollution and improve the world’s most important bilateral relationship

PUBLISHED : Thursday, 16 February, 2017, 5:17pm
UPDATED : Thursday, 16 February, 2017, 8:51pm

US President Donald Trump wants a great deal for America. China can offer one on natural gas. It can bring hundreds of billions of dollars to the US economy and offer the best and, probably, the most economical solution to China’s pollution catastrophe.

The US has experienced a revolution in oil and gas production. Its shale oil accounts for over half its total oil production, making the US one of the largest oil producers in the world. Its shale gas has surged in output, making it one of the largest gas producers in the world.

On the other side of the Pacific, China’s oil production is falling. Its natural gas production is stagnating, despite repeated government prodding for higher output. China remains stuck with coal for two-thirds of its energy needs. Lately, use of the dirtier but cheaper brown coal has grown rapidly, adding to the environmental nightmare.

America’s success in shale energy and China’s failure reflect better endowment for the former but, more importantly, the triumph of entrepreneurial drive and the free market. The oil and gas sector is usually dominated by state-owned enterprises, like in China and Russia, and, in some countries by huge multinational companies. The US shale sector is very fragmented in ownership and production. Entrepreneurial dynamism is driving its rapid technological innovation.

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Ironically, China’s coal sector has grown rapidly due to the same entrepreneurial force. Coal production is largely from privately owned mines. Even though most are small, they have managed to rapidly increase production to fuel China’s industrial rise in the past two decades. Without private enterprises in the coal sector, China couldn’t have grown so much.

If China continues to use coal to meet demand, the environmental damage could bring down the country

In contrast, China’s gas market is stunted by state-sector inefficiency. China’s gas price is three to four times America’s and about 50 per cent higher than the liquefied natural gas landing price in Asia. The reason is that China’s energy producers want to pass on their cost, which includes the supply contracts signed at very high prices.

China must abandon pricing on cost and benchmark prices to global levels. Otherwise, it cannot improve its environment.

One big loss is the inability for trucks to switch to natural gas from diesel. It is easy and cheap, and makes a big difference to the environment.

It goes to show that China’s environmental catastrophe is mostly due to systemic failures rather than economic development per se.

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China’s energy consumption may rise at 2-3 per cent per annum for the next two decades and decline after that, as population decline outweighs income growth. At its peak, energy consumption in China would be about the same as that in the US today. If China continues to use coal to meet this demand, the environmental damage could bring down the country.

Considering how bad the situation is now, China should cap its coal consumption. In particular, it should use coal only in power plants. About half of the coal is used now to supply energy to households off the grid; they should be forced to switch to electricity or natural gas. That would improve the environment tremendously.

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Most of China’s future demand for energy must be met by natural gas. Renewables and nuclear power are not ready to play that role. But, China’s state-owned energy players are unlikely to rise to the challenge. They have shown low efficiency, little innovation, and an inexplicable waste in investing in bad foreign assets at peak prices. Without fundamental ownership reforms, which is unlikely, China’s gas demand will have to be met by imports.

Here is the synergy between the US and China. America’s gas prices have declined over the past decade, reflecting declining production cost due to innovation. This is different from global oil prices, which have fluctuated violently on geopolitics or monetary policy. The US gas market is much more like a normal manufacturing industry. This makes it a more reliable supplier in the long run.

China’s gas imports may exceed the total US consumption today, possibly by a wide margin. The Middle East has the reserves but not the system to meet all the demand. Russia and Central Asia will always be of high cost. The US could emerge as the supplier of gas at sufficient volume, at the lowest cost, with the least volatility.

The US economy depends on the growth of its energy sector. But demand saturation seems to be limiting its growth despite the low price. Its ability to export depends on building very expensive liquefaction plants. Without long-term offtake agreements, this sector is unlikely to take off.

In the long run, China’s demand could make the bilateral trade balanced, removing a major thorn in the Sino-US relationship

This is where China could come in. If China could offer long-term contracts, it would immediately spark an investment boom in the US and lift its economy. In the long run, China’s demand could eventually make the bilateral trade balanced, removing a major thorn in the Sino-US relationship.

China would benefit greatly. The shift to a clean fuel would help remove the biggest barrier to its growth. Stable and low-priced gas supply is in its long-term interest. As an added benefit, the demand for LNG tanks could revive its troubled shipbuilding sector. This is a big win-win.

Some people in China would certainly be worried about depending on the US for energy. What if the US wanted to harm China by cutting supply? In international trade, there is always such a risk. The world has become so dependent on trade because the mutual benefits outweigh other considerations. If the US builds expensive liquefaction plants for Chinese demand, it would suffer more from any trade disruption. Here is a bond that can last.

Andy Xie is an independent economist