Impact of China’s looming power shortage

1 Jun 2011 | Research | Bjørnar Tonhaugen

Energy & Metals Market Update:

China to suffer largest power shortage since 2004 this summer on drought and high coal prices.

We see upside risk to our Brent price forecasts in H2 2011 on increased oil and diesel demand.

Aluminium and steel production to be most affected by power cuts. Upside risk to prices.

Summary

Southern and central parts of China are currently experiencing the worst drought in 50 years. Besides having serious ramifications for households concerning drinking water and food crops, the drought may exacerbate the expected power shortage during the summer when demand peaks. The power shortage will have a significant short-term impact on energy and metals markets if the current estimates prove to be right or even too conservative.

Oil markets will tighten more in the second half of this year than what is currently embedded in our forecasts. Increased demand for diesel used in stand-alone power generation may increase by 300k barrels per day, turning China again into a net importer as in 2008. We see upside risk to our current Brent price forecasts in H2 2011 of USD 117.50/bbl.

Coal markets will be positively impacted by an increase in China’s net coal imports. Hydropower is expected to be constrained compared to normal potential. Coal demand would be increasingly supported by further increases in state-controlled power prices. This would also reduce the negative effect on metals production.

Metals markets will be impacted by production cuts in aluminium and steel, while other base metals will most likely remain unaffected. We forecast production losses of around 3% for aluminium and steel. The global aluminium deficit for 2011 would widen to 500k tonnes according to our estimates. We see upside risk to our aluminium price forecasts of USD 2,600/tonne for the remainder of this year. The effect on steel prices will probably be in the range of 3-5%, slightly less than for aluminium, despite likely higher production cuts. China is a net exporter of steel. Thus, the largest effect from the lower production will show through as lower domestic availability.

China’s power situation

China’s rapid economic growth the last decade has been accompanied by even larger growth in electricity consumption. Electricity generation has increased 11% pa the past ten years compared with an average real GDP growth rate of 9.8% pa over the same period. China’s power generation mix is still dominated by coal-fired capacity. Fossil fuel-fired capacity represents roughly 75% of total installed capacity. Hydropower represents roughly 22% of the total, with nuclear and other renewables making up the remainder (Chart 1).

Power generation capacity in China by energy source

Power generation capacity in China by energy source

Source: International Energy Agency, Nordea Markets

China is thus reliant on a significant share of hydropower each year and the ongoing drought threatens to limit the hydropower potential this summer. Hydropower production is highly seasonal (Chart 2). The share of hydropower production peaks in the summer when total production/demand peaks. Hydropower production year to date has increased 18% versus last year, probably due to limited coal-fired generation. Furthermore, hydropower production in April only increased 1% compared to April last year even though total production increased by 10.5% year on year. It’s still too early, however, to gauge the full impact of the drought on monthly hydropower production data. Nevertheless, seasonality implies that monthly production in the summer months will have to double from April levels just to match last year’s production.

Several industry groups and national agencies have recently warned about the biggest shortfall in power supply this summer since 2004, when potential demand exceeded generating capacity by 10%. The latest estimates from China Electricity Council point to a potential shortfall of 5% of installed capacity. This translates to approximately 49 GW based on installed capacity of 985 GW. Chart 3 shows the areas expected to experience power shortages this summer and their respective shortages.

Provinces affected by power shortage

Provinces affected by power shortage

Source: Reuters

The power shortage is exacerbated by the fact that coal-fired producers are facing poor or even negative margins. Coal prices have increased sharply recently (Chart 4), but electricity prices are fixed by the National Development and Reform Commission (NDRC), see Chart 5. Several coal-fired power plants have reportedly been shut down due to poor economics, with utilisation rates reportedly as low as 60%. The shortage situation was partly alleviated this week as China will raise electricity prices for industrial users – but not yet for residential users – in 15 provinces by 3.5% from 1 June. This will make room for increased on-grid power tariffs, prices paid to power producers by grid operators, and boost coal demand through power production.

Implications for energy and metals markets

The power shortage will have to be met by demand reduction and to some extent by increased use of stand-alone generating capacity fired by distillates such as gasoil/diesel. Should the power shortage materialise as forecast, we expect a combination of reduced production of energy-intensive materials, such as aluminium and steel, and increased imports of diesel fuel for power generation. The sections below present our view on energy and metals markets in more detail.

Impact on oil

Oil and distillates (gasoil/diesel) demand in particular has increased substantially during previous power shortages due to increased use of gasoil/diesel-fired generators. During the major power shortage in 2004 and the power rationing in 2008 and last autumn/winter, diesel demand and imports increased markedly (Chart 6). Last month, China banned diesel exports in a preemptive move to tackle the potential shortage this summer. Gasoil/diesel demand will increase both structurally and seasonally in the coming months. The oil market balance will be additionally tightened should the power shortage play out as expected. The IEA estimates that gasoil/diesel demand could increase by 300k b/d. Global crude runs (crude oil demand from refineries) are expected to increase seasonally in the third quarter by over 2m b/d – twice as much as the OPEC output increase – before taking the effects of China’s power shortage into account.

We believe the full extent of the power shortage is not priced in yet, leaving room for a boost to oil prices should the situation play out as expected. In 2008, an important factor to the run-up in oil prices was the increased demand for diesel for power generation in China.

Impact on coal

Prior episodes of power shortages have not shown any visible effects on net imports, as China has been largely self-sufficient. Still, we expect a positive impact on China’s net coal imports this time around (Chart 7). China became a net importer in the middle of 2009 when the surge in domestic coal prices made imported coal economically feasible. We believe in further increases of state-controlled electricity prices to alleviate the power shortage, but the government’s concern about inflation will limit any large price increases. This will boost coal demand since hydropower is expected to be constrained compared to normal.

Impact on metals markets

China consumes roughly 40% of global metals output and is also a large producer of refined metal. China produces more steel than it consumes, produces roughly all of its aluminium consumption and produces roughly two-thirds of its copper consumption. Table 1 below outlines Chinese base metals and steel production, demand, imports/exports (numbers in million tonnes) and their energy intensiveness. It also shows each of the metal’s consumption of electricity in TWh and their relative share of China’s total electricity consumption.

Aluminium and steel production most likely to be curbed

Source: Bloomberg, Reuters, Nordea Markets

Aluminium and steel clearly stand out as large electricity consumers with 6% and 12% of total consumption, respectively. Production of the other metals combined consumes only 1% of China’s electricity. Furthermore, as Chinese net imports of nickel and copper equal a large share of demand (39% and 32%, respectively), we doubt that China will curb its copper/nickel production to any extent since this will put strong upward pressure on prices, we believe. Any production cuts will thus most likely only take place in aluminium and steel.

Impact on aluminium and steel

Aluminium and steel production was curbed during the latest period of power curbs in H2 2010. Chart 8 below shows aluminium and steel production (annualised) since 2004. In the latest round of production cuts in 2010 (to achieve the goals of the previous 5-year plan) China reduced its production of aluminium by 1.1m tonnes and steel by 39m tonnes. The production losses totalled 7.1% and 5.6% of annual aluminium and steel production, respectively.

Historically, Chinese aluminium production cuts have been greater than for steel. This time we see two main reasons for the opposite:

Approximately 65% of Chinese steel production is located in the provinces affected by power shortage versus 42% for aluminium (see Table 2 below). While the latest round of production cuts was evenly spread out, the forthcoming cuts will be more determined by the specific energy situation in each area.
China is a net exporter of steel and balanced in primary aluminium. It is always easier to cut when the domestic market is left unchanged

Steel production most at risk of cuts

Steel production most at risk of cuts
Source: Bloomberg, Reuters, Nordea Markets