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Nagging concerns

Like an itch that just doesn''t seem to want to go away, concerns over the impact of China''s growing levels of exports and the world''s alarmingly high energy prices are continuing to keep many processors up at night. And that''s not all processors have to worry about. China''s manipulative energy policy affords its domestic plastic processors an unfair competitive advantage.

As emerging markets like China and India continue to develop ever-increasing appetites for energy, and as energy consumption rates also rise in the more traditionally gluttonous markets like the U.S., global supplies are beginning to show signs of strain, a phenomenon that is sending oil prices through the roof. For plastics processors selling to the world market, higher energy prices might be a small price to pay for an expanding global market, but this energy burden is not being shouldered equally among the world''s processors.

What the numbers say

A look at natural gas prices around the world helps illustrate the story. In February 2005, prices for natural gas ($US/mBTUs) were recorded at $7.05 in the U.S., $1.60 in Argentina, $.75 in Saudi Arabia, $4.55 in China, $3.15 in India, $5.25 in the UK, and $.95 in Russia. The pricing scales for crude oil and gasoline follow a similar pattern.

Whereas rich oil and gas reserves in many places like the Middle East and Russia offer some market rationale for lower prices, in other markets government intervention has had to play a more direct role in sheltering producers from soaring prices. While many Asian economies subsidize the price of their retail energy products, by virtue of its colossal size and industrial output, China''s subsidized energy program has had a particularly serious impact on global competition.

China''s growing influence on energy prices has only been exacerbated by its very inefficient use of energy. In 2004, China''s oil consumption per unit of GDP was double the rate of the developed-world average, while countries like the U.S. and Japan have managed to significantly reduce their oil intensity ratios. Since the early 1970''s oil efficiency in the U.S. has improved by around 50%, while Japan''s oil efficiency has increased by more than 80%.

Whence protectionist pricing

The Dept. of Price, a bureau within China''s National Development and Reform Commission, sets the domestic wholesale price of natural gas and petroleum products for China''s major energy companies (all state-owned). This price-setting is ostensibly intended only to control inflation. However, since prices are set below market levels, Chinese manufacturers are given an additional pricing advantage over competitors operating in open energy markets.

Dr. Kang Wu, an energy expert on China and head of the China Energy project at the East-West Center, explains that in the past, while Chinese energy prices were kept below international levels, they were at least partially influenced by market forces, fluctuating with listed prices on the Singapore, Rotterdam, and New York exchanges (although the GOC never released the exact formula nor the weight given to the prices for each exchange). However, when international energy prices began to skyrocket in 2003, the government backed away from this more market-directed approach and implemented a more obscure and protectionist pricing policy. This has had the effect of maintaining artificially low domestic energy prices. While the GOC has increased domestic energy prices five times in 2005, Dr. Wu estimates that prices are still about 20-30% below their international market value.

Energy specialists with the U.S.-China Business Council tell us state-run refineries have been forced to operate at a loss during a period where facilities in other markets have been cashing in on the increased demand for fuel, an outcome that has spawned resentment within China''s three major energy firms. Rumors even suggest that this resentment may have recently been expressed through a series of illegal "work slowdowns" at several Chinese energy facilities.

This situation has created a dilemma for the GOC. On the one hand, keeping energy prices low grants Chinese exports an additional pricing edge and helps to keep inflation at bay. On the other, forcing losses on state-owned energy companies, which must also answer to their limited but influential shareholders, ferments resentment among powerful investors.

For foreign processors competing with Chinese firms, the implications of this policy are clear. China''s pricing manipulations allow domestic plastics processors to, in effect, export the country''s subsidized energy in the form of plastic goods, cashing in on the high energy prices that their competitors must pay.

This policy of subsidized energy has also exacerbated other irregularities in Chinese competitiveness, like the artificially maintained value of the Chinese yuan and the lending policies of China''s national banks. The combined effects of these policies have made it even more difficult for international processors to compete against Chinese firms that already enjoy the advantage of low labor costs.

In late 2004, the GOC released some hopeful statements indicating that it was considering an "oil price reform scheme," which would supposedly introduce a more market-driven pricing mechanism for wholesale and retail energy sales. However, to date the government is still in the discussion stage; and for the moment it remains unclear whether liberalized reforms would apply to industrial users. Energy specialists like Dr. Kang Wu feel that although the GOC is likely to continue to allow gradual adjustments, it would be overly optimistic to expect any major reforms soon.

Putting the pieces together

The world economy is entering a potentially disruptive period. While energy prices have yet to derail forecasts for continued global economic growth, some storm clouds are beginning to appear on the horizon. Inflationary signs are popping up in key consumer markets like the U.S. and Europe; these higher inflationary pressures are likely to only increase the already high consumer demand for low-cost Asian imports, creating a snowball effect.

If current projections hold true, energy prices should not reach the breaking point. Leading energy agencies like the U.S. Energy Information Admin. (EIA), for example, are still projecting higher average oil prices in 2006, but do not predict dramatic increases from current levels. Similarly, natural gas prices are also projected to climb throughout the remainder of 2005 and on into the first part of 2006, then begin to slow and fall during the second half of 2006.

What makes this period so troubling is that energy prices are riding along a steep precipice where any major disruption in supply or sudden increase in demand could shoot oil prices well into the inflationary stratosphere. This vulnerability was recently seen following the devastating Hurricane Katrina, which greatly diminished domestic production and distribution of oil and natural gas in the United States.

On the one hand, you have several factors that are likely to create momentary spikes in the market, like disruptive weather and natural disasters, the ongoing insurgency in Iraq (one of the world''s top oil producers), periodic terrorist attacks in Saudi Arabia (the world''s largest oil exporter), a deepening nuclear deadlock with Iran (read possible UN sanctions), and a growing animosity between Washington and Caracas (President Chavez has hinted that he is considering shifting Venezuelan''s oil exports from the U.S. market to China''s).

On the other hand, there are more long-term pressures like the diminishing number of new oil discoveries and rising global demand, which is being led by China''s relentless economic growth.

Net results

All of these factors put current energy forecasts on very shaky ground, and they are likely to change at a moment''s notice depending on the news of the day.

The test of how well the economy can handle the continued strain from high energy prices might come this holiday season. If prices for gas and heating waylay holiday sales, we could start to see steady downward growth for U.S. and European producers.

In other words, the ability of the U.S. consumer to continue to consume at the established pace is going to be put to the test; and many experts are not so sure how well they will cope. During the first two oil shocks of the 1970s, average personal saving in the U.S. measured around 9.5%; by the 1991 Gulf War oil shock, average personal saving was estimated at 7%. Today, rising personal debt has slashed savings. Aside from the precarious equity accumulated during the current housing bubble, personal savings rests at 0% and has recently even dipped into the negative, giving U.S. consumers very little room to absorb higher energy costs.

Within this context, China''s program of manipulating energy prices exacerbates the tenuous position that international energy markets face. Artificially low energy prices encourage abnormally high consumption rates, well above what the market would permit under normal circumstances. In markets with relatively low output levels, the results of this intervention would not be so harmful, but in a market as large as China, the effects can actually disrupt normal international pricing. Furthermore, the advantage that this subsidized program offers Chinese manufacturers is only likely to be exaggerated as U.S. consumers continue to seek out ways to offset their own rising energy costs.

Much pressure has recently been directed towards encouraging a more market-oriented currency regime in China. It may now be time to expand that pressure to include a more liberal energy policy.

Agostino von Hassell [email protected], and Mark Bella [email protected], of the Repton Group LLC (New York).

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