Wednesday, July 27, 2005

Crude Guess: Most Analysts SeeYuan Move Lifting Oil Demand

By PATRICK BARTA Staff Reporter of THE WALL STREET JOURNAL July 27, 2005

Investors wondering how last week's yuan revaluation will affect Chinese demand for oil and other key commodities can be forgiven for scratching their heads in confusion.
Commodity analysts issued a frenzy of research reports, many of them contradictory, after China moved to raise the value of its currency against the U.S. dollar by 2.1%. UBS analysts suggest that global oil prices might now rise with "possibly higher" Chinese buying. Merrill Lynch, meanwhile, offered what amounted to a three-pronged forecast: more demand for crude in the near term, "possibly" weaker demand in six to twelve months, and overall stronger demand in the long run.
Some analysts even contended investors shouldn't worry much about the revaluation at all, given its small size -- and the confusion it caused. "I'm certainly not going to get excited about it," said Jim Lennon, a commodities analyst at Macquarie Bank in London.
The truth is, it's still too early to know for sure how the revaluation will affect oil and other commodities, partly because it isn't clear if China will follow up with additional yuan increases and, if so, when.
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But a few things are clear. First, a stronger Chinese currency gives Chinese importers more purchasing power to buy oil and other commodities. If the yuan's value rises further, so too would China's buying power. All things being equal, that should allow China to scoop up even more oil, iron ore, coal, nickel and other basic materials than it does today.
Second, the impact of China's beefed-up buying power, while important, is likely to be overshadowed in the long run by the overall performance of China's economy, which itself will be affected by currency revaluations. If currency revaluations result in a meaningful slowdown in Chinese exports by making them more expensive to the outside world, and overall growth ebbs, China's demand for oil and metals would inevitably drop.
But if the currency revaluations result in a more balanced Chinese economy by giving domestic consumers more power to buy autos, air-conditioning units and other commodity-intensive products, China's appetite for raw materials could wind up being sustained for many years to come. Right now, the consensus seems to be that the latter outcome is more likely, because few economic analysts believe the Chinese economy will slow substantially any time soon.
So ABN Amro Holding has advised clients to boost holdings of resource-company stocks, notably Australian mining concerns, as the Chinese currency appreciates. Like many banks, ABN Amro likes the two big regional players with the broadest exposure to minerals: Anglo-Australian mining giants BHP Billiton and Rio Tinto.
Similarly, UBS predicts that in the Asian-Pacific region, basic-materials stocks in general are likely to see "positive moves" as a result of the upward valuation of the yuan, although the bank remains less bullish about steel as China boosts its domestic production.
The picture for oil, however, is a lot more complicated. The latest data suggest that China's oil-import growth has already slowed, and the International Energy Agency in Paris recently downgraded its forecast for Chinese oil demand this year.
But it's unclear if those trends reflect a fundamental decline in underlying oil demand, or a temporary pause caused by imbalances in the Chinese marketplace. Many analysts prefer the second explanation, partly because they believe oil demand was restrained earlier this year as Chinese companies worked off stockpiles accumulated in 2004.
Also, many analysts believe Chinese refineries cut back on imports recently not because of weakening demand, but because of eroding profit margins. Because the Chinese government regulates domestic prices for refined petroleum products, keeping them artificially low, refineries can't jack up prices whenever their input costs rise. That may have encouraged some refineries to throttle down production this year rather than pump out refined products at a loss, or to shift some of their production to be sold outside of China.
In a move last week that drew less attention than the currency revaluation, Chinese authorities raised retail diesel prices by 6% and gasoline prices by 6.4%.
"This makes a big difference to the profitability of local refineries," which in turn should boost their ability to buy more oil, analysts at Barclays Capital said in a report late last week. Barclays recently predicted a ninth consecutive quarterly increase in the average global price of crude oil in the third quarter, with prices for West Texas Intermediate crude expected to average $60.10 a barrel. That would mark an increase of just under $8 a barrel from the previous quarter and would be the largest quarterly increase in the past two years.
Similarly, National Australia Bank warned in a recent research report that "reports of [oil demand's] death are greatly exaggerated." NAB noted that China's refiners plan to add about 330,000 barrels a day of new capacity during the next two years, with much of that capacity designed to handle lower-cost heavy and sour crude.
As that capacity comes online, the bank contends, it should give Chinese refineries more room to maintain profit margins even if consumer prices stay capped, which in turn should encourage them to keep buying oil.
As a result, "we may see a return to the demand growth I expected to see in China," which is greater than the recent trend, says NAB analyst Gerard Burg.
In the long run, China's oil consumption will still be driven by how well the economy holds up with a stronger currency, and by the overall cost of oil to the consumer, rather than by short-term issues related to refining capacity.
At least one analyst, David Thurtell of Commonwealth Bank of Australia in Sydney, still believes demand will ultimately cool. As some analysts note, continued increases in the yuan's value could give the Chinese government more room to raise consumer fuel prices without triggering inflation -- the one step that many analysts believe is needed before China can seriously curb its thirst for oil.
By Mr. Thurtell's reckoning, once all of China's moves last week are factored in, oil products are actually more expensive for the average Chinese consumer today than they were before the revaluation.
"At the end of the day, the outlook is for China to remain strong and commodity demand to keep going," Mr. Thurtell says. But "it's hard to see Chinese fuel consumption rising [a lot more] when they've just raised prices 6%."


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