The Daily Reckoning PRESENTS:
While food is necessary for survival, energy is necessary for growth...and no country is growing at a faster clip than China. Their demand for energy increases everyday, and Justice Litle explores their strategies to ensure energy security. Read on...

China’s oil demand has doubled over the past decade, and the pace is only increasing. There will be ups and downs along the way: When the current infrastructure boom and the flood of foreign investment slow, energy demand will slow for a time also. But in the long run, the trend is inexorably steep. Consider this from The Economist (from “The Hungry Dragon,” September 2004):

“In around 20 years’ time, China’s income per person could be close to South Korea’s today. If its energy consumption per person also rose to current South Korean levels, its energy demand would quadruple. The increase alone would be greater than America’s total consumption today, yet China’s energy use per person would still be only half that in America. At present there is only one car for every 70 people in China, against one car for every two Americans. If car ownership were eventually to rise to American levels, there would be 650 million cars on Chinese roads - more than all the cars in the world today.”

How is China going to ensure energy security with such a tall order to fill, let alone generating capacity for such incredible demand? First, by developing strategic ties with key energy producers who prefer an alternative to the “Bush doctrine” of the United States; second, by investing in local production and alternative energy sources that will reduce reliance on imports over time.

With key producers like Venezuela and Russia already in place, and with Canada as a long-term energy source, China’s secondary focus is on alternative energy.

Through development of local resources and investments in cutting-edge technology, China can further close the energy gap and reduce dependence on outside partners. To this end, China is upgrading its nuclear power capabilities and investing heavily in advanced technology that will turn coal into petroleum products. It is in this area where Western investment opportunities remain; while it is not feasible to invest in the Venezuelan or Russian governments, China cannot avoid partnering with Western companies when access to technology is required.

Nuclear power is a natural choice for China. The standard “green” objections to nuclear power simply do not exist in the Middle Kingdom. Furthermore, China has awful problems with water shortages, air pollution and acid rain. A nuclear alternative could remedy some of these issues by substituting nuclear energy for fossil fuels and removing stress from the environment. Nuclear power has another green aspect as well: It produces virtually zero carbon dioxide, and thus does not contribute to global warming.

China has plans to develop a new type of reactor design known as a PBMR, or pebble bed modular reactor. The pebble bed reactor is theoretically cheaper and easier to build than traditional PWR (pressurized water reactor) plants. The pebble bed reactor also has a safety edge in that it is supposedly “meltdown proof”: The reactor’s uranium “pebbles” (actually the size of billiard balls) are coated with high-density carbon, preventing exposure in the event of a coolant leak. Thus, in theory at least, the disasters of Chernobyl and Three Mile Island could not happen with a PBMR. Furthermore, because the pebble bed reactor design is modular, extra generating capacity can be added over time, allowing for further development as needed and less lump sum expense for initial construction.

China is in competition to develop the first commercially viable pebble bed reactor with a consortium led by Eskom, South Africa’s state-run utility firm. Eskom claims to have a lead in technological development over China, but an environmental challenge in the South African courts has created a legal hurdle Eskom must clear. (China, of course, does not have to trifle with those annoying bits of democracy that oppose national interest.) First-mover advantage is a potentially valuable prize, with the opportunity to license PBMR technology and construction to other countries hungry for an inexpensive and safe energy source. Eskom may still be in the running for a commercial product even if China gets there first; while China’s main focus will be developing a new energy source quickly and building rapidly, Eskom’s niche could be in developing more safeguards and design efficiencies, worth the larger price tag for more prosperous (and litigious) societies, where any nuclear solution must meet stringent high standards.

On another experimental front, China is spending more than $3 billion on a coal-liquefaction plant in Inner Mongolia. The Shenhua Group, China’s largest coal producer, has partnered with a U.S. technology provider to convert coal into petroleum products. In a nutshell, the process involves breaking coal down into hydrogen-enriched molecules, which are then converted to traditional oil products. According to Zhang Yuzhou, vice president of Shenhua Group, “The project consists of two phases of construction, and after the second is complete, the plant aims to yield 5 million tons of oil products annually and greatly reduce China’s reliance on crude oil imports.”

The economic viability of coal liquefaction hinges on the cost of crude. Oil must remain above a breakeven point of approximately $32 a barrel for the process to be profitable. If the price of oil falls below $30 for a sustained period of time, the liquefaction plant may prove to be a costly albatross. But this is a risk China is more than willing to take, especially given the boost in energy security that internal production provides. As China continues on a path of dramatic growth, reliance on oil imports is expected to grow steeply in percentage terms as well, so alternative energy investments would do well just to keep pace with this trend; if oil imports represent less than half of consumption in the year 2020, China will have won an important strategic victory.

The winners and losers in China’s quest for energy security revolve around transport, exploration and technology. China’s demand for oil imports will rise inexorably over time, even as their internal energy sources come on line. This will create a rising demand for tankers, which in turn may benefit shipbuilders over the long cycle. As oil economics turn in favor of further exploration, there will be more opportunity in development and wildcat-style exploration projects, with big profits to the winners and heartbreak for those who come up dry. Look for the oil majors to participate indirectly in any exploration boom as well, spreading their risk through funding and backing of smaller players.

And of course, alternative energy technology is coming into its own. For the past few decades, alternative energy was simply not an economically viable option: Crude oil was too inexpensive, the initial development costs too high, to take alternatives seriously. But now, the development seeds are being sown, with compelling economics on the horizon for fossil fuel substitutes. In this arena, the companies positioned to profit most are those with hands-on intellectual property...alternative technologies that can be sold, licensed or leased but not easily copied or stolen, due to implementation requirements and need for hands-on expertise.

With the 20th century’s books now closed, China looks to the 21st...and they know it is their time. In this new century, the dragon will rise again. As investors, we ignore China’s destiny at our peril. Whether we see China as friend or foe is irrelevant; in fact, whether or not China fully succeeds in its ambition is irrelevant. What is certain is that China’s strategic actions, and the resulting reactions, will dramatically alter the global landscape. We are in the beginning stages of a sea change.

© 2005 Justice Litle
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Editor's Note: Justice Litle is an editor of Outstanding Investments. He has worked with soybean farmers, cattle ranchers, energy consultants, currency hedgers, scrap metal dealers and everything in between, including multiple hedge funds. Mr. Litle also acted as head trader for a private equity partnership, and made contributions to Trend Following: How Great Traders Make Millions in Up or Down Markets, a popular trading book by Mike Covel (FT/Prentice Hall, 2004). In addition, Justice Litle has been quoted in the Wall Street Journal and by multiple financial newswires, such as Dow Jones and Future Source.