“Too many people in the modern world view poetry as a luxury, not a necessity like petrol. But to me it’s the oil of life.” – Sir John Betjeman, English poet, writer, and broadcaster
“Oil is like a wild animal. Whoever captures it has it.” – J. Paul Getty
“Gold is a treasure, and he who possesses it does all he wishes to in this world, and succeeds in helping souls into paradise.” – Christopher Columbus
“We Spaniards know a sickness of the heart that only gold can cure.” – Hernan Cortes
China imports a lot of oil and produces very little of it. And for all its progress, the People’s Republic has been able to do very little in overcoming its dependence on the black stuff. In fact, even a cursory glance at a time series of Chinese import statistics shows that, China is becoming increasingly more dependent on oil imports.
This is the price China pays to be the ‘factory of the world’.
China Oil Imports
Source: BP Statistical Review
Oil is priced in US dollars. Oil importing nations have but no choice to hold US dollars. This is ‘American Privilege’.
No wonder then when the price of oil goes up, especially when US dollars are becoming increasingly difficult to come by, oil importing nations suffer a liquidity squeeze and see their economic performance deteriorate in short order.
The price of Brent crude averaged US dollars 54 per barrel last year; year-to-date it has averaged almost US dollars 72 per barrel – close to a third higher. It follows then that the stock markets of many of the largest oil importers amongst the emerging economies have had a torrid time of it this year.
Emerging Market Indices Year-to-Date Total Return (US dollars)
Source: Bloomberg, Note: MSCI Indices
China, if it is to realise its economic and geopolitical ambitions, must overcome this oil price and liquidity conundrum. Unless China discovers the equivalent of the Ghawar oilfield in Saudi Arabia or undergoes a Permian like shale revolution, the solution to this problem is likely to be found in a reconfiguration of Chinese capital markets.
In March this year, China launched renminbi-denominated oil futures, which coincidentally is also the first Chinese futures product that can be traded by overseas entities without a presence in China. Simply launching an oil futures contract, however, is not enough especially for an economy with a closed capital account.
While the prospect of a renminbi-denominated oil contract may appeal to oil exporters, such as Russia and Iran, that have suffered from the weaponised dollar, the contract on its own provides nothing more than a case of out of the frying pan and into the fire. Most oil exporters, we suspect, are far more willing to trust the United States than China given the status quo. For this reason, China must do more to provide the necessary comfort to oil exporters to trade in renminbi and a means for them to swap their renminbi for other more freely tradable assets.
China has taken steps to provide two alternatives to anyone settling physical deliveries in renminbi. The first is the equivalent of the US petrodollar model whereby renminbi receipts can be recycled into Chinese bonds with the gradual opening up of the Chinese bond market. The second is the back-to-back conversion of renminbi-denominated oil contracts into renminbi-denominated gold contracts for physical delivery in gold.
The latter solution is particularly intriguing because it eliminates the need for trust and rewards exporters in the form of an unencumbered asset.
Thought Experiment
From Wikipedia:
A thought experiment considers some hypothesis, theory, or principle for the purpose of thinking through its consequences. Given the structure of the experiment, it may not be possible to perform it, and even if it could be performed, there need not be an intention to perform it.
With China completing the first physical delivery for crude futures yesterday, we think it a good time to think through the non-conspiratorial implications of the oil for gold structure that China is offering for oil settlement.
The relevant statistics to think this through are as follows:
- Chinese oil imports have now reached 8.4 million barrels per day or 3.066 barrels per year
- At US dollars 70 per barrel that translates into an annual oil import bill of US dollars 214.62 billion; growing at 3 per cent per annum this would take Chinese spending in oil imports to over US dollar 315 billion by 2030
- Chinese gold mine output is estimated at around 450 tonnes per annum and expected to rise to 500 tonnes by 2020
- At US dollars 1,200 per troy ounce, Chinese gold mine output of 500 tonnes translates to US dollars 19.29 billion; at US dollars 1,600 per troy ounce it translates to US dollars 25.72 billion
- Global gold production is estimated 3,150 tonnes per annum
- At US dollars 1,200 per troy ounce, global gold production is valued US dollars 121.53 billion; at US dollars 1,600 per troy ounce translates to US dollars 162.04 billion
At current oil and gold prices and assuming China only uses gold flow and not stock to fund its oil imports, the People’s Republic can only pay for about 12 per cent of its oil imports using its annual gold mine production. Moreover, even if China was to buy 100 per cent of the gold mined in the world (it cannot), it would still only be able to pay for approximately 57 per cent of its oil imports in gold.
Lest we ignore the obvious, buying the equivalent of annual global gold production neither solves China’s problem of having a large commodity related import bill nor does it end its reliance on US dollars.
China needs a 9x re-rating of the gold-to-oil ratio for the oil-for-gold structure to be a wholesale solution to its oil-liquidity conundrum. Unless the cost of mining gold relative to the cost of extracting oil increases nine fold, there is little to no economic basis for such a re-rating. For this reason we doubt that the oil-for-gold structure is the most feasible solution to the problem. Moreover, it does not seem, to us at least, a sound thesis for investing in gold.
For those who can, investing in Chinese government bonds, we think, is a better bet than investing in gold in expectation of the gold-to-oil ratio re-rating 9 times higher.
This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.