china-oil.jpgIn the depths of a global recession, demand for oil usually drops and with it, the oil price. Yet the price of oil has leaped more than 100% since February and is currently at an eight-month high.

Economists may scratch their heads, but in China the inexorably march upward of the oil price is cause for more than just academic concern.

The Financial Times' excellent Energy Source blog recently interviewed Jeff Rubin, chief economist at CIBC, on the impact that a rising oil price will have on global trade and, particularly, China's traditional export-led economic model.

Some blame the latest hike in the oil price on speculators or on investors getting ahead of themselves in predicting economic recovery. But even if prices do fall back, the relief is likely to be temporary and the longer-term trend seems inexorably upward. The era of cheap oil, which coincided with China's economic ascendancy, has gone for good.

That's not just bad news for the new Chinese owners of Hummer. Who wants a 2.5-ton Tonka Toy that does 14 miles a gallon if gas prices soar once more to $3 a gallon, as they did last summer?

It is bad news for a large swathe of Chinese exporters, which have already been badly hit by global recession and may soon have to contend with higher transport costs if the oil price moves much above the current $70 level. Rubis says:

It wasn't that long ago – maybe four or five years – that today's depressed level would've been described as an all time high. If what was an all-time high only five years ago is where oil trades in a very deep recession, where does oil trade going forward? Once we get into triple digit prices, what we find is it's no longer compatible with a global economy… distance costs money and things that we thought made a lot of sense like importing food or steel from China cease making sense. “

Much of the success of China's export-led economic model was predicating on the assumption that supply chain costs for most manufactured goods were sufficiently modest that they would be more than compensated by the labour costs savings achieved by making the goods in China, even if the goods had to be shipped half way around the world.

This “death of distance” model leads to the sort of paradoxes that western shoppers experience on a daily basis — asparagus flown thousands of miles from China to US and European supermarkets invariably sell for less than home-grown asparagus. Taste is another matter.

The growing awareness of the hidden environmental cost of these “food miles” has caused more consumers to question the wisdom of this model in the food industry, although I suspect it will be the soaring oil price rather than consumer sensibilities that finally cuts the food miles on western shopping lists.

In other industries, the paradox is, if anything, even more pronounced. Tyres are a relatively low-value product that is bulky and presumably difficult to ship. Yet Chinese manufacturers, almost overnight, have grown to take a 17 percent share of the US tyre market and caused 7,000 job losses among domestic manufacturers, at least that is what the United Steelworkers argues in its recent complaint with the International Trade Commission.

You would expect heavy iron castings to be safe from low-cost Chinese competition. Yet CAF, a Spanish maker of trains and metros, now buys unfinished castings from China rather than from the local suppliers that historically supplied it, despite the obvious logistics challenges in shipping the castings half way round the world.

In another twist to the distance-no-object story, CAF is now in competition with Chinese train manufacturers for a big order with UK railways. Among four companies invited to tender to supply 200 new passenger coaches for British train operators is Chinese Sourced Railway Equipment, which is owned by the Chinese government. Two China State Railways subsidiaries have also won an order to supply three 200 kph trains to UK operator Grand Central.

Until recently, these cases would be seen as simple manifestations of a globalised economy. Efficient supply chains and China's plentiful supply of low-cost labour combine to give Made-in-China goods a huge advantage over western competitors. Rubin says:

The global economy is mostly about wage arbitrage… but the implicit assumption is that we can move goods and not just finished goods, [but also] the intermediary inputs around the world – that distance does not cost money.”

This assumption will be less valid as oil prices rise higher. Rubin says China has already begun to lose advantage in the North American steel market because it was not economically feasible to ship the steel from China. He continues:

There's not a whole lot we can do to stop oil prices getting back to tripe digit prices, because the very oil we're relying on requires those extraction methods.. (But) we can make sure the next time we see those figures, we can reduce the impact that will have on our economy.”

Why Your World Is About to Get a Whole Lot Smaller: Oil and the End of GlobalizationThe single most important thing we can do is go back to a local economy, Rubin says. This theme of the end of globalisation is explored in a lot more detail in Rubin's recent book (pictured).

So instead of making trains, computers and t-shirts primarily for export, China will have to learn to make things to be sold primarily at home. It may have started already. BreakingViews reports that a diktat from several Chinese ministries suggested that government projects should favour domestic suppliers in spending the country's fiscal stimulus money.

Still think that the rising oil price is purely down to speculators? To be sure, with the US, the largest oil consuming nation, still in recession, many analysts believe that it is difficult to see a sustained recovery in the oil price no matter how upbeat the figures on China's economy — the OECD has just revised China's GDP growth prediction for this year upward to 7.7% from 6.3%.

But the US will emerge from recession and if China, the world's second largest oil consumer, maintains its strong demand for oil, then you do not have to be a peak oil theorist to predict that the oil price is more likely to increase than decrease in future years.

To keep its GDP growing at 6% to 10% a year, China's energy demand is forecast to grow by 150% by 2020. Food for thought.

Hat tip to The Infrastructurist.

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