By All Means Necessary (5 page)

Figure 3.1 Chinese Consumption and Production of Select Resources.

Sources
: U.S Geological Survey, “Iron Ore,” Mineral Commodities Summaries (1996–2011). Annual Publication; BP, BP Statistical Review of World Energy June 2012 (London: BP, 2012); U.S. Department of Agriculture, “Production, Supply, and Distribution Online,” Foreign Agriculture Service. Accessible at
http://www.fas.usda.gov/psdonline/psdHome.aspx
. Accessed August 2012; World Steel Association data (accessed August 8, 2013 via Bloomberg); World Bureau of Metal Statistics data (accessed August 8, 2013 via Bloomberg); China General Administration of Customs data (accessed August 8, 2013 via Bloomberg); authors calculations. Data series for iron ore and bauxite are truncated at 1995 due to lack of reliable data.

China became a net oil importer in 1993 and a net natural gas importer in 2007.
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It moved from depending on iron ore imports for only 3 percent of consumption in 1981 to more than half by 2003, while similar trends prevailed for other mineral resources.
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Beijing ultimately had no choice—and neither did the rest of the world. China is a central part of global markets for a host of resources, and its impacts are being widely felt.

The most immediate consequence of growing Chinese demand for natural resources has been rising prices for a host of critical commodities. The widely followed Commodity Research Bureau (CRB) Index comprises nineteen publicly traded commodities, including oil, natural gas, copper, nickel, sugar, and wheat, and is a useful, if crude, indicator of worldwide commodity prices. Between January 30, 2002, and July 2, 2008, the index nearly quadrupled.
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Crude oil prices rose eightfold over the period.
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Copper prices began their steep ascent in 2003 and ultimately rose to twenty times their original level.
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Wheat prices stayed relatively steady through 2007, but by the middle of 2008 they too had risen by a factor of four or more.
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Many people quickly pointed to China as the culprit behind these and other commodity price increases. Resource demand in developed countries had been relatively stagnant. Emerging economies such as India and Brazil still consumed too few natural resources to make such a big impact on world markets. Chinese demand—first for energy, then for minerals, and finally for food—was thus a natural place to turn for an explanation. By 2010, China accounted for 38 percent of global copper demand, 42 percent of aluminum use, and similar fractions of world consumption for other metals.
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It also consumed 23 percent of world soybeans along with more than 10 percent of world oil.
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Observers projected the trends into the future and warned of ever-rising resource prices for years to come.
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But assigning blame to China for high and rising prices requires more than merely observing that Chinese demand and world prices rose at the same time. High and growing demand does not automatically imply high prices; world oil prices, for example, were lower in
1970 than at any time in the preceding hundred years, despite the emergence in the interim of the automobile and oil-powered industry and a resulting explosion of oil demand.
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High prices require a second critical factor: supplies must be so scarce that prices end up rising strongly in order to boost production and curb consumption until supply matches demand. Moreover, prices are affected by a host of factors other than how much a single consumer uses, including broader economic growth, technology, and resource availability, any of which can in principle overwhelm changes attributable to China. As a result, not all natural resources have been (or will be) affected in the same way by rising Chinese demand. Understanding how various resource prices respond can give a valuable clue as to how China might affect resource prices in the future.

Start with oil. At the turn of the twenty-first century, most forecasters predicted inexpensive oil for decades to come.
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A barrel of crude would cost $20, perhaps $30 in the extreme. Few foresaw the rise to nearly $150 a barrel that ultimately occurred, and many pointed to Chinese growth as the cause of the higher prices that materialized over the course of the 2000s.

Indeed, Chinese demand for oil has grown faster than many expected. But the discrepancy is not nearly as large as most assume, and it alone is not enough to explain what happened to prices. In particular, if oil markets had worked the way most analysts assumed they did fifteen years ago, they would have accommodated the Chinese rise. Then, the dominant assumption was that big oil producers in the Middle East (perhaps along with other members of OPEC) would expand production to accommodate growing world demand without allowing prices to rise much. This would have kept prices from rising strongly even with surging Chinese demand.

But OPEC countries didn't react this way to the emergence of China. World oil production didn't jump; instead, it was actually far smaller by 2010 than most had projected a decade before. It is the combination of greater Chinese demand and smaller-than-expected world supplies that explains why prices have risen so much.

But this isn't the end of the puzzle: why did supplies fall short? Some experts contend that the shortfall was due to strong limits on how much affordable oil lies underground. But that is a minority position; most experts believe world oil resources remain vast.
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Instead the low amount of oil production is usually chalked up to decisions by oil producers (and occasionally to wars) that put oil off-limits or otherwise deter developers from producing it.

Indeed, it turns out there is good reason to conclude that Chinese growth helped spur many oil producers to hold supplies back. Many governments put development of their natural resources in the hands of state-owned companies or otherwise control them tightly. Many of these companies aim to meet set revenue targets rather than maximize profits. Thus they have little incentive to expand production in the face of rising prices. Indeed, since higher prices can allow them to meet their goals even with less production, high prices can actually prompt them to curb production, or at least reduce incentives to boost output, leading prices to climb.
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What does this have to do with China? These dynamics require a spark, something that initially pushes prices higher and begins the cycle of production restraints and higher prices that result. Strong (and to some extent unanticipated) Chinese demand does the job. More important, absent strong growth in world oil demand, stagnant production from state-controlled oil producers would have led to declining oil prices and falling revenues, creating incentives for those producers to expand. Rapidly rising Chinese demand allowed oil producers to grow their revenues without increasing their production. The side effect was higher prices for everyone.

This dynamic helps explain what happened over the past decade. It is also likely to prevail for the foreseeable future, so long as China continues to demand more imported oil. As its demand continues to rise, many state oil producers will find themselves with little incentive to boost supplies, allowing prices to remain high. Absent a significant downshift in oil demand—a possibility we will return to later—the only way out is if oil production elsewhere in the world comes on strong, squeezing state-owned oil producers' profits and encouraging them to pump more. Indeed, in recent years oil production in the United States and Canada
has surged, leading some to speculate that high prices may soon come to an end.
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Those production gains may help moderate the high prices brought on in part by Chinese growth. But they are subject to two important limits. Chinese oil demand growth will continue to be high, and it will be difficult for gains in U.S. oil output (and production from other free-market economies where U.S. technology is employed) to meet it fully. Moreover, oil prices must be relatively high in order for strong U.S. oil supply growth to be profitable, which rules out low prices like those that prevailed fifteen years ago.

In contrast with oil, it is difficult to pin rising natural gas prices directly on Chinese demand. Natural gas markets are often more balkanized than oil markets. Transporting natural gas across long distances is expensive; as of early 2013, for example, the cost of liquefying natural gas, shipping it from the United States to Japan, and turning it back into gas at the destination was several times the price of the gas itself.
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The alternative to seaborne transport is pipelines, which are more cost-effective over modest distances but create rigid relationships between suppliers and customers, making buyers vulnerable to the political whims of sellers on the other end. For these reasons, growth of the global natural gas trade has been relatively weak, with most large countries, China included, preferring to source most of their natural gas at home. China also has the option of using oil or coal (depending on the use) instead of natural gas. The result so far has been a relatively low import level and, as a result, limited immediate impact on natural gas prices beyond China.

Yet China has still influenced natural gas prices indirectly through its impact on oil markets. World markets for oil and gas have long been closely connected. Most natural gas has historically been produced as a byproduct of oil extraction, keeping the costs of oil supply and gas supply closely tied. Oil and gas have also long been important substitutes for each other in power generation, industry, and home heating. This has kept the prices for the two commodities from getting too far away from each other. And since much of the world's natural gas is sold at prices determined through formulas that are based on oil, rising oil prices—partly due to growing demand from China—have further driven up the price of natural gas.

Metallic ores present another story; indeed, the impact of Chinese demand on world metals prices is as diverse as the metals themselves. Copper and bauxite—two of the most significant commodities traded by China—tell two very different stories.

Chinese demand for both metallic ores has grown strongly and now constitutes a large fraction of world demand. But the consequences differ. Spot prices for copper rose fourfold between 2000 and 2011 in the wake of surging Chinese demand.
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(“Spot prices” are prices at which commodities are traded on “spot markets, ” which are characterized by one-off exchanges among buyers and sellers, in contrast with sales under “term” contracts that set pricing rules for trade over periods ranging from weeks to decades.) The initial reason for escalating prices was slow response from miners, who faced long lead times for new projects; high prices were therefore required to restrain demand. After crashing during the financial crisis, copper prices rose again, still reflecting slowness in expanding supply but also the increasing cost of producing new copper.
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Countries that host mines have also pushed for higher wages and greater government shares in profits, raising operating costs further.
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In addition, iron ore has seen strong price gains akin to copper, and for similar reasons: rapidly rising demand and slow-to-catch-up supply.

Bauxite, though, has responded differently. Despite increases in both Chinese and global demand similar to those seen for other base metals, bauxite prices have not risen as much.
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What explains this difference? One theoretical possibility is that other consumers easily cut back on their use of aluminum (for which bauxite is a raw input) in the face of rising Chinese demand. This sort of “flexible” demand would prevent total world consumption from rising much and thereby keep prices restrained. But it turns out that demand for aluminum is highly unresponsive to prices (even more so than demand for copper), so this theory doesn't work.
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Moreover, bauxite mining involves lead times similar to what is seen in other base metal mining, and it is fairly concentrated in a small number of countries, so neither slow supply response nor concentration is a good explanation.

Three other factors likely explain why bauxite prices did not rise much. First, even before the emergence of China, industry was expecting strong growth in bauxite demand (particularly for the replacement of steel with aluminum in cars as well as other uses) and had put in place plans to meet it.
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(This suggests that producers of other minerals, now conditioned to expect rising demand, may be able to meet Chinese growth in the future with far smaller price rises than were experienced between 2000 and 2010.) Second, China has a large amount of relatively high-cost bauxite production capacity that comes online to keep rising prices in check and then shuts down when prices fall.
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(This, however, may become a smaller factor over time, as growth in Chinese bauxite demand—and more fundamentally aluminum demand—greatly outpaces domestic supply.) Third, not only are world bauxite resources massive, they are also well understood. This reduces risk for those who seek to increase bauxite production, which in turn makes it less likely that the costs of developing bauxite mines will turn out to be surprisingly high, sending prices upward.

Bauxite thus offers an important lesson: surging Chinese resource demand does not always lead to the sorts of massive price rises that are typically assumed. Industry-level details—particularly on the supply side of the equation—matter. So does the predictability of demand.

Despite the coincidence of strong growth in prices for energy, minerals, and food, China's actual impact on food markets has been considerably smaller than its influence on other commodities. Researchers commissioned by the UK government capture the prevailing view among experts well: “It has been suggested that the rapid rise in incomes in China and India is the main cause of the [2007–08] food price spikes, ” they write, “but this direct effect is unlikely.”
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Demand for agricultural commodities, they observe, actually rose more slowly in the 2000s than in the 1990s, a decade when global food prices were stable. High food prices in recent
years are better explained by a mix of broadly rising demand, volatile weather, demand for crops and cropland to produce automobile fuels, and moves by major food producers (notably Russia and India) to throttle back food exports in the face of these events, further intensifying the resulting price rises.