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As we continue to wait for a resolution to the uprisings in the Middle East and Africa, and try to guess how the domino effect will further affect oil prices, markets continue to price short-term uncertainty and delivering wild fluctuations as news are disseminated — some correct, others simply rumors. If the predictions of $200 oil hold true, whether it’s WTI or Brent, it shall be short lived and the impact on prices at the pump can be best calculated by using a common ratio of 2.5 cents per $1 in oil prices. Thus, an increase of $100 from current values, and barring other events such as refinery destruction and disruption, would translate into an additional $2.50/gallon, bringing us to pay about $6 per gallon to keep our automobiles on the move. Definitely not the end of the world, but businesses that depend on consumer discretionary income would be the first in line to suffer greatly, such as the local pizza parlor. Other parts of the world, where gasoline is heavily taxed to support bloated public sectors, such as European countries, would suffer even more. Unsustainability is the key word.

But one of the common mantras is that China’s demand, even in the absence of conflict, will continue to propel oil prices higher, especially when China’s economy captured the number two position in the world. The cynical will not be amazed by the accomplishment, but ask instead "What took so long?" And let’s not forget that growth took place on the backs of developed countries. Japan took second place a long time ago — 1968, I believe — with only about 1/10th of the population. For the Chinese economy to be on the same footing as Japan, from an average citizen’s purchase power perspective, China’s GDP (purchasing power parity) would have to grow by over 460% from it’s current value, to over $45 trillion. Furthermore, China is number 127 in the world in the GDP per capita ranking, according to the CIA’s World Factbook, putting China behind countries like Jamaica and Ecuador — and there lies the fallacy of using individual numbers out of context as gospel.

But when estimating oil consumtpion, certain key factors must be examined. For example, the Chinese government claims that inflationary pressures must be contained, especially in real estate, but land prices raise an interesting issue. According to Caixin, "Chinese law stipulates that any farmland to be converted for non-farming use must first be nationalized. This gives land monopolization power to local governments, which in turn have become a core reason for most of China's present social and economic problems." It certainly is not the same as the U.S. housing bubble, because the Chinese government is behind the problem, not the common freewheeling citizen with access to cheap credit. So why the interest rates increases? The mysteries keep on coming — or not — and that is only a smoke screen which shall be addressed in due time.

But China is now determined to slow its economy, although the official statements and subsequent actions are contradictory. With the right hand they increase bank reserve requirements and interest rates, while the left hand continues to dispense loans as if inflation is non-existent. I already stated the reason in a previous post, and I include it here as a refresher, with Dorris Chen delivering the simplest and true explanation.

According to Bloomberg, China set a target of $1.1 trillion in new loans for 2011, exceeding estimates by Bank of America and UBS. Meanwhile rates are being raised - equivalent of turning your furnace on and A/C at the same time. "This is a positive surprise to the market and is likely to trigger a rebound in banking valuations," Dorris Chen, a Shanghai-based analyst at BNP Paribas SA. "The economy needs this amount of credit to keep existing projects running instead of turning them into a pile of bad loans."

Also as a reminder, China was already trying to slow the economy one year ago, as reported by the New York Times on February 2010, but they truly cannot accomplish the feat because they have painted themselves into a corner, and the factors and ramifications are far too numerous to cover in this piece.

From a debt perspective, which goes to the fiscal soundness of the country and its consumption prowess, the Chinese government claims that the ratio of debt to GDP is very low as compared to the U.S., Japan, and others. Accessing accurate information is extremely difficult and the lack of transparency should raise enough red flags, especially when China wants to be a viewed as a serious economic powerhouse. But the truth may be that the Chinese Debt/GDP ratio is higher than in the United States, and keep in mind that central, regional, and local governments all answer to one master. Caixin Online, a Chinese website, aimed a flashlight at the issue, with the article "Peering into a Black Hole of Government Debt."

The campaign push offers clear proof that local government debt risk is now an agenda-level concern of central government leaders. But clearly documenting the risks of local government debt is not easy: Relations between local governments and various types of debt vehicles can be overt or covert, and statistical standards vary among regulators, preventing a comprehensive, accurate picture of the scale of local government debt.

In short, financial chaos. Victor Shih, a respected economist at Northwestern University, suggested that China’s hidden borrowing will push government debt up to 96 percent of GDP in 2011, as reported by Bloomberg last year, although we may never see that figure in official statements. Mr. Shih "spent months researching borrowing transactions by about 8,000 local-government entities," and as we move forward, the fascination with China will receive a dose of reality as is the case with most everything else that lacks a solid foundation. I call China "The Evolving Nightmare" — or dream come true depending on who’s looking — and the stage is set for a reduction in general commodity consumption by the Chinese economy.

Having examined the core issues facing China’s economy, although in a succinct manner, what will happen to oil, even if only from a desire to slow down China’s economy? Sounds pretty obvious, especially if one believes that China is the consumption engine that keeps on giving. The U.S. market, the largest absorber of Chinese products, thus providing an indirect stimulus for China’s commodity consumption, is still in frugal mode, and week after week we see yet more signs of lackluster oil demand. For example, while this week’s gasoline inventories dropped 5.5 million barrels, current inventories are still "above the upper limit of the average range," according to the EIA, while oil inventories rose again. Furthermore, "Refineries operated at 82.0 percent of their operable capacity last week," or the lower range of historical levels as demonstrated by the chart below.

(Click to enlarge)

If we apply straight line economics, China’s oil imports should continue its growth spurt without hesitation, especially when the most common, simplistic analysis out there dictates that over 1 billion consumers "will" naturally expand demand as they transform into middle-class citizens. But no one country operates in a vacuum, insulated from economic shocks, and what is quickly becoming artificial and unsustainable Chinese growth, adds more questions than answers. C1 Energy, a Chinese oil and gas market reporter and pricing agency, gave its forecast for 2011 recently, as reported by tradingmarkets.com.

The total consumption of crude and oil products in China is expected to reach 457 to 458 million metric tons (tonnes) this year, increasing 4 to 5 per cent year on year, and the growth will be 7 percentage points lower than last year.

Certainly China is a large market in simple terms, but its position as the number two economy is not as absolute as taking the silver medal at the Olympics, and a simple assumption that oil supply is shrinking while China keeps burning it in a manner that discounts the contribution of the developed world, will set the stage for disappointment. In addition, and potentially as a small window into current economic developments, I share the following article from the The Seattle Times reporting an easing in Chinese auto sales, although some attribute the decrease to the Lunar New Year holiday.

China's voracious demand for cars eased in February, as surging gasoline prices, the end of government subsidies and a major holiday took a toll on the world's biggest auto market.The China Association of Automobile Manufacturers reported Wednesday that total sales including buses and trucks fell 33 percent in February from the month before to 1.27 million vehicles. Sales of passenger cars dropped 37 percent to 967,200 vehicles.The 5 percent increase from a year earlier for all vehicles and 2.6 percent rise for passenger car sales represented the slowest pace of growth in more than two years.

The same article went on to point out that "China's vehicle sales in January-February rose about 10 percent year-on-year to 3.15 million, while output climbed 9.6 percent to 3.1 million vehicles, the report said. But that compared with an 84 percent jump in sales in the same period of last year." Thus, the Lunar Year factor is hard to digest. The government cannot afford to keep the tax incentives alive, and for the Politburo to create the perception that the government is still in control, an economic slow down is portrayed as being part of central planning — just like I can say that I lost a basketball game because I wanted to. No, I sucked!

On the debt front, especially as the U.S. is concerned, we hear often that the Chinese will stop buying U.S. bonds. Although our politicians should get our fiscal house in order, if China stops the purchases it is because they can’t afford it, not because they don’t want to. Here are a few words of wisdom from Luo Ping, director-general at the China Banking Regulatory Commission, in a speech in New York in February 2009, as reported by the Financial Times.

"Except for U.S. Treasuries, what can you hold?" he asked. "Gold? You don’t hold Japanese government bonds or UK bonds. U.S. Treasuries are the safe haven. For everyone, including China, it is the only option." Mr Luo, whose English tends toward the colloquial, added: "We hate you guys. Once you start issuing $1 trillion-$2 trillion [$1,000bn-$2,000bn] . . .we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do."

And in Mr. Ping’s words lies the wrinkle when added to China’s own problems. There’s not enough money to go around and cover American, European, and Asian debt, and while some will rush to gold to protect against the impending disaster, don’t be so quick because before that happens, the austerity measures necessary to keep the world functioning will be forced upon everyone, while interest rates will increase to cover risk, not to mention taxes.

Lastly, there are investors with deep pockets already betting on China’s demise, although their strategies are diverse, not well defined — at least publicly — and may have been a bit premature. Much like Gaddafi, the Chinese government will keep the current charade intact for as long as possible, and determining the breaking point may become elusive, although there is no escaping it.

The Economist published the article "Waiting for the Great Fall," stating that "Bears also believed that the high degree of state direction in the Chinese economy was not an advantage, as many admirers liked to imagine, but a chronic weakness that fostered opacity, corruption and the misallocation of capital." Thus far the meltdown has not occurred, although the Shanghai Index is virtually unchanged for the past 18 months, hardly an indication that the global investing community is avidly looking to place its chips in Chinese companies.

If making your mind up about whether China will get into trouble is hard, the mechanics of betting against it are tricky too. "I’ve encountered a huge amount of interest over the last year in shorting China," says someone based in Asia who advises hedge funds on the country. But because short-selling is mostly prohibited in mainland China, it is only practical to bet against the shares of those mainland companies that are listed offshore, mainly in Hong Kong and New York.

Tim Moe, chief Asia-Pacific strategist at Goldman Sachs, said the bank had "held on too long to our overweight position in China last year," referring to 2010, and added that "the longer-term picture of Asia outperforming the U.S. is taking a breather," although short positions in the American and Hong Kong exchanges are still at a very low level.

But as the Economist’s article points out, "’Mega-bears’ are still a small minority. But as any short-seller will tell you, being lonely is just the precursor to being right." And while trading oil and dreaming of riches can be extremely fulfilling, doing so under assumptions that are questionable at best will lead to disappointing results, especially when this thing we call "Global Economy" is telling us that something is amiss.

Source: China, Oil, Debt and Reality