Natural Resources

China’s looming energy crisis (Part II of II)

China has a massive looming energy crisis that few seem to focus on. Part I explained how two thirds of the country’s energy comes from coal and that China’s coal is running out fast. Part II will look at what is being done about it and what it means for investors.

You might think the answer to China’s problem is just to import more coal. And in fact this is what China has already been doing. The country had a production deficit of 9 million tonnes in 2003, but that had swelled to 85 million tonnes by 2013. That’s still only 4% of total Chinese coal consumption of 1.9 billion tonnes, but it’s up nearly tenfold in ten years.

Coal is not a global market in the same way as oil or liquid natural gas are. It’s regional at best.

The problem with coal is that it’s bulky, heavy and dirty stuff. This makes it difficult and expensive to transport. Oil and natural gas can be pumped down pipelines and in and out of tanker ships. Coal has to be piled up, and shovelled, and dropped, and shovelled, and piled up again at every stage in the transportation. For this reason most coal exports are over relatively short distances. Coal is not a global market in the same way as oil or liquid natural gas are. It’s regional at best.

Given all this, China is in a scramble to develop new energy sources, particularly for electrical power generation. Oil is one option, but in 2013 domestic production was already only 40% of consumption, and China’s proven oil reserves to production (R/P) ratio is less than 12 years (similar to the USA but much lower than the world’s 55 years).

So shifting power production from coal to oil just creates a new problem. Plus oil is just another dirty power source like coal, and most of the imports would likely have to come from the Middle East. That means relying on an unstable region and running the gauntlet of the US navy on the high seas. China is not yet in a position to challenge the US in that regard.

That leaves hydroelectric power, other renewables (solar, wind, geothermal, biomass and waste), nuclear and natural gas. Between these sources China has to replace much of its current coal usage and cope with ever growing overall power demands as well.

There are only so many rivers to dam, so we can assume there is little or no growth potential here. In fact China already produces a quarter of the world’s hydroelectric power.

Let’s deal with the renewables first. China has already made massive investments in hydroelectric power, most famously with the Three Gorges dam on the Yangtze river, the largest power plant in the world. China gets 7% of its energy from hydro, which is the same as the world as a whole. There are only so many rivers to dam, so we can assume there is little or no growth potential here. In fact China already produces a quarter of the world’s hydroelectric power.

What about other renewables? For all the political, environmental and media coverage, combined these made up just 2.2% of world energy sources in 2013 (latest BP figures). Admittedly that was up a lot from 0.7% in 2003, but it’s still just the tip of the iceberg.

The sun doesn’t always shine (clouds, smog and night time!), the wind doesn’t always blow, and not all coastlines are suitable for wave or tidal installations. Geothermal, which involves extracting heat from deep underground, may have potential as a reliable source. But it depends on geography and is still practically developmental. Even biomass involves burning waste (pollution) or redirecting valuable farmland away from food (e.g. maize/corn for ethanol).

Global renewable energy production grew 15% a year between 2003 and 2013. At that rate, with compounding, we may find in a couple of decades 10%, 20%, or even 30% of world energy consumption comes from renewable sources. The current leaders in this area are Spain (13% of energy used) and Germany (9%).

China has invested in renewables as well, but at less than 2% of total energy usage it still has a long way to go, in common with the world as a whole. China already lays claim to over 15% of total global renewable energy, which is not that far behind the USA’s 21%. Especially given that China is a relatively poor developing country.

For now much of the renewables technology is still experimental, or unreliable, or unsuitable in many locations. It remains at the margin and China needs vast amounts of energy that it can depend upon. Now.

This leaves just two realistic alternatives for reliable, large scale base power sources: nuclear power and natural gas.

Nuclear power has a bad reputation because of occasional but catastrophic nuclear accidents, such as Three Mile Island in 1979, Chernobyl in 1986 and Fukushima Daiichi in 2011. But it also has the advantage of producing no carbon emissions.

Of course the highly radioactive waste has to be dealt with, usually by burying it deep underground for future generations to worry about. But in terms of solving immediate energy needs it has major attractions from an air pollution and energy security standpoint.

One of the most important of these is that the uranium fuel is only a small part of the production cost. Most of the cost is in construction of the power plants to extremely high safety standards. This makes it easy and cheap to stockpile uranium fuel for decades to come.

China is already operating 26 nuclear reactors, has 23 currently under construction and more planned.

Unsurprisingly, China is investing heavily in nuclear power. According to the World Nuclear Association China is already operating 26 nuclear reactors, has 23 currently under construction and more planned.  I’ve written about the potential impact of expanding nuclear power on the uranium price before (see here). Although it hasn’t taken off yet the fundamentals of uranium still look strong for investors.

The last alternative is natural gas. It’s still a fossil fuel, but burning it is a whole lot cleaner than burning coal or oil. It produces roughly half as much carbon dioxide when burnt as coal. Increasingly you can run vehicles with it as well.

The cheapest way to move gas around is through pipelines. Luckily for China it shares a land border with the country with the world’s second largest natural gas reserves: Russia.

That makes it difficult for foreign powers to interfere with the supply if they so choose in future (and yes, I mean the US navy). Russia wants to sell gas and China desperately needs to buy it. This is a match made in heaven.

But fortunately for China heaven didn’t have to intervene. The USA and Europe lent a helping hand instead.  By poking their noses into Ukraine, supporting the coup d’etat there, trying to locate NATO military bases ever closer to Russian borders, and imposing economic sanctions on Russia when it reacted, they have provided a strong catalyst for a logical outcome. The bear and the dragon are now strategic best friends.

So after talking about it since the 1990s China and Russia finally agreed to two mega deals in 2014 for Russian gas to be pumped across the Siberian border into China, both worth hundreds of billions of dollars. Why rely on selling gas to Europe, much of it transiting through pipelines in Ukraine, if you can sell it to China instead?

Admittedly it will take a few years for the pipelines to be finished. But this is a genuine “win-win” on a massive scale for both countries. And it’s just part of an ever deepening strategic relationship between them.

China is facing a very real energy crisis if it doesn’t get its act together to replace coal as its dominant source of power. Clearly the government is aware of this and taking steps in the right direction. Only time will tell whether they have left it too late. I suspect they’ll sort it out in time.

But whatever happens, fellow OfWealthers, both uranium and natural gas look like they are in the sights of the world’s biggest energy consumer. Investors should act accordingly.

Stay tuned OfWealthers,

Rob Marstrand

robmarstrand@ofwealth.com

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.