- Oil is China's biggest import - Oil price strength pushing inflation higher - Currency revaluation should follow

By Greg Peel

As Libya descended into civil war and Saudis threatened a Day of Rage, the price of Brent crude reached a peak above US$116/bbl. The Saudi protest did not materialise and thus took some of the heat off the oil price, but it is the immediate reaction to the Japanese earthquake, tsunami and nuclear disaster which sparked a fall in the oil price to around US$105/bbl before bouncing back to US$110.

That reaction is not necessarily a simple response based on the expectation of lower Japanese oil demand in the short term. It is a wider exit from risk at a time when nuclear meltdown fears are enough to encourage a shift out of the “risk trade” and back into cash. That gold should also be caught in the sell-off at a time of global fear is testament to the fact recent commodity price spikes are more about speculation than anything else. The MENA unrest has simply not, for example, caused a supply shock as yet. The same amount of oil has been flowing each day with Saudi Arabia in particular making up the shortfall from Libya.

But speculators see the risk of a supply shortage, and hence have piled in. Even before the MENA unrest began, the simple expectation of growing commodity demand out of the likes of China and India had commodity funds loading up on energy, food and metal trades. The irony is that these are often described as an “inflation hedge”, yet the inflation is being generated by the speculation itself. Realistically this means “bubble”.

For China, it means simple price inflation. Beijing can bitch all it likes about Western speculators (at least one US oil company CEO has suggested West Texas crude would be at US$50 instead of US$100 if you took out the speculation) but the reality is China is importing that inflation via its currency peg to the US dollar. Were Beijing to allow its currency to revalue to where it should realistically be trading, then price inflation would be wiped out in China. Australia, for example, has not suffered the same price-at-the-pump inflation as the US given the release valve of a rising Aussie dollar.

Food price inflation is often focused upon in China. Despite a rapidly growing middle class, there remains among China's more than a billion people a large proportion of low income earners for whom the weekly food bill is their largest proportionate cost. They are thus hit harder by a jump in the price of rice or pork, for example, than would be the case in Western countries. But the real inflation risk is undeniably oil. In 2010, China imported US$2.5bn worth of soy beans, US$4.5bn of copper, US$7.9bn of iron ore but a whopping US$15.7bn of oil, as ANZ's economists note.

China is now the world's second largest user of petroleum products after the US, consuming 8.9m barrels per day, ANZ notes. Like the US, China does have its own oil reserves but also like the US (and Australia), China consumes more than it produces. In 1993 China switched from being a net exporter to a net importer and now it imports 55% of consumption.

China has taken aggressive steps to reduce its oil intensity (ie increase efficiency) but still it consumes 81 tonnes of oil per thousand US dollars of GDP compared to the US on 60t and Japan on 39t. Given the extent to which China's economy has now moved along the maturity path, this figure is a poor score, ANZ suggests. And there is little doubt China's oil demand is on a rising trend.

Beijing has set an inflation target of 4% or lower. The latest monthly data showed a 4.9% reading in February – unchanged from January. Note that People's Bank of China monitors headline inflation (including food and energy costs) while other central banks, such as the Fed and RBA, seek to control only core inflation. US headline inflation remains very low despite the oil price, whereas large per capita oil consumer and high level importer Australia is looking at headline inflation of only 3.6% at present given the floating exchange rate effect.

In another hangover from its communist days, China is also subject to consumer energy price controls. The government previously kept the price of petrol, for example, at a low level and wore the cost itself of price rises but too much strain was placed on the fiscal budget in the lead up to the 2008 oil price peak of US$147/bbl. This meant a couple of nasty step-jumps in price for consumers, but as oil prices once again sail above the US$100 mark even Beijing's interim solution – a shifting petrol price mechanism triggered once crude trades beyond a given range – is causing fiscal strain. Beijing marks its “world” oil price off an unpublished weighted basket of Brent, Dubai and Cinta (Indonesian) crude prices.

In the hope that the recent MENA-related oil price spike proves to be temporary, Beijing has even been holding off on those petrol price adjustments, meaning consumers have been subsidised at the expense of state-owned oil companies, ANZ notes. Where might the true level of Chinese inflation actually be? In 2008 China was forced to speed up its painfully slow currency appreciation to alleviate oil company losses, and ANZ suggests this could happen again.

In the medium term, suggests ANZ, Beijing could increase its strategic stockpiles of oil, and steps have been made to encourage private sector stockpiling to smooth the impact of price volatility. In the longer term, China needs to reduce its oil intensity and increase its reliance on other energy sources, especially renewables. Beijing's current plan is to increase the proportion of renewable contribution to 15% in 2020 from the current 8%.

In the short term however, it all comes down to just where the oil price is going to settle. More than half of China's oil imports come from only four countries – Saudi Arabia (19%), Angola (16%), Iran (9%) and Oman (7%). It's not exactly a Top Four of political stability at present. By contrast, the US imports more oil from each of Canada, Mexico and Venezuela than it does from Saudi Arabia.

Once again taking the immediate Japan-related volatility out of the oil price for now, ANZ is among those who believe there will not be an oil price pullback soon once things settle down in MENA. ANZ's forecast is for a Brent price of US$110/bbl by end 2011.

MENA may take a long time to settle down of course, and the situation can yet get a lot worse than now if deterioration of incumbent control is seen in the likes of Saudi Arabia, Iran or Iraq. Even if, for example, Gaddafi were to fall tomorrow, some analysts suggest it might take years before foreign oil companies are again prepared to risk their investment (and lives) to provide Libya with much needed assistance on further developing reserves and infrastructure. Then multiply that scenario across the whole MENA oil producing zone.

Returning to the Japan effect, once the initial commodity fund exodus has run its course, attention can then turn to just how much additional oil Japan might need to compensate for lost nuclear power production.

The reality is oil prices are currently very volatile and oil price inflation has become China's biggest economic threat (the property bubble doesn't seem to rate a mention anymore). The risk for Chinese trading partners such as Australia is the double-whammy of a high oil price drag on Chinese economic growth, and further monetary tightening to fight inflation.

Australia would not, however, suffer were Beijing to accelerate the appreciation of the renminbi in isolation. Australia's floating exchange rate squares the impact (via the US dollar) given greater Chinese purchasing power would offset the higher Aussie.

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