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THE OUTLOOK FOR ENERGY IN THE NEW NORMAL AN INTERVIEW WITH ANDY XIE

WITH CHINESE PEOPLE IN THE MOOD TO JUST BUILD, BUILD, BUILD, CAPITAL-INTENSIVE BUSINESSES WILL HAVE TO WAIT OUT THIS PERIOD. IT MAY TAKE FIVE YEARS OR SO, BUT, UNTIL CHINESE PEOPLE SLOW DOWN, THEIR OVERCAPACITY WILL CONTINUE TO DEPRESS MARGINS

OPINION: ANDY XIE

ANDY XIE: INSIGHTS ON THE NEW NORMAL

Andy Xie is renowned for his provocative views on the Chinese economy and formidably accurate predictions; he was one of the few economists to forecast the South-East Asian financial crisis of 1997, the dot com bubble of 1999 and the US sub-prime mortgage bubble that led to the 2008 global economic downturn. Here, the independent economist reveals his views on the prospects for China and their potential impacts on the global oil and gas industry.

In recent years, energy demand growth has swung from the developed world to the developing economies, notably in Asia and most dramatically in China. However, although China is now the world’s largest energy consumer and the second largest oil consumer and it will soon become the world’s largest oil importer, its strong growth is slowing. The Chinese government has been warning that the years of double-digit economic growth are over and talks of a new normal in which growth will be below 8%.

What steps can global oil industry executives take to ensure that their businesses remain competitive in this uncertain new world?

It is difficult to overstate the importance of China to the global oil industry. Its rapid industrialisation has driven energy consumption tremendously, but Xie predicts that China’s energy consumption growth rate will become sluggish – around 3% he estimates, whereas it used to be 10% – because the country now appears to be heading towards a less industrially driven and, therefore, less-energy-intensive future. And, at the global level, he predicts a 2% growth rate, down from 4% during the boom years.

Consequently, we should expect prices to be hugely affected. Xie draws parallels between the oil industry and the iron ore industry,

where it takes three or four years for the production from capital investments to come on line. “In the iron ore industry right now, global demand is stagnant but more and more production is coming on line. So what happens? A price war that squeezes out the high-cost producers.”

He goes on to talk about small iron ore mines in China where the running costs were comparatively high. Their competitors in Australia and Brazil cut prices and increased production, so the Chinese mines were forced to shut down.

China’s growth over the last two decades has been driven by building its manufacturing base. But today, capital is cheaper and more accessible than it has been for a long time, and the utilisation rate of those investments is starting to decrease. Consequently, Xie asserts that China has overinvested and that the ongoing effect of this will be depressed margins. For example, he says China’s annual steel-making capacity is 1.2 billion tonnes, but demand is some way behind at 800 million tonnes. Moreover, that demand is likely to fall. There is similar overcapacity in other industries, especially the global refining industry, he adds.

OPINION: ANDY XIE

For refiners to remain competitive, Xie suggests that they should focus on relentlessly driving out inefficiencies. Like the refining industry, the steel industry has been experiencing overcapacity and cutthroat competition for many years, but there are still profitable steel companies in China, he says, because they have been incredibly successful at minimising waste and maximising efficiency.

He also recommends that firms should take steps to maximise the value of arguably their greatest asset: human capital. “The key is to nurture your own people and develop an elite labour force inside the company. For a large company to have an edge, it has to have a core of people with a sense of ownership of the company. Allegiance-based humanresources policies are far more effective than market-based ones.”

He cites the example of the Chinese network equipment and devices giant Huawei Technologies, which hires fresh recruits from universities and has its own campus to educate them. It has created an incentive structure to tie everybody up with the company’s success.

“Success breeds its own success. It is a virtuous cycle; the people who work there expect to have a great future there, so they stick around,” he says.

“That is the only solution in my view. Some companies talk about hiring hotshots, people who are going to be the panacea to all the company’s challenges, but that is not going to work for very long.”

SOUND BITE: NO NEED FOR DESPONDENCY IN INDONESIA

Although Indonesia was once considered one of the hottest emerging markets, in 2014, its growth rate fell to its lowest level for almost five years, 5.1%. Despite this, Xie remains positive about the outlook for the world’s fourth largest country by population.

“A lot of Indonesians compare their country with China and are very dissatisfied, but I think that Indonesia is already doing very well,” he says. “It has a huge resource base, from oil and gas, through tin, nickel, copper and gold to agriculture, forestry and fishing. And it has deep connections with China, which gives it another important advantage.”

He continues, “You cannot expect Indonesia to be China, yet. Be patient; it is growing at 5% a year, so give it 10 years and there will be a huge difference. I am very hopeful that Indonesia will keep on going like that for the next 15 years. It has overcome incredible difficulties to become a stable democracy and that is something that not many countries accomplish. It is in very good shape.”

OPINION: ANDY XIE

WHAT I SEE NOW IS THAT THERE IS A GENERATION OF MONETARY POLICYMAKERS IN EMERGING ECONOMIES THAT ARE DOING THINGS RIGHT.

SOUND BITE: FIRM POLICY IS THE KEY TO BRAZIL AND OTHERS STAVING OFF FINANCIAL CRISES Just a few years ago, Brazil was enjoying rapid growth but its economy decelerated significantly in 2011 and 2012, from 7.5% in the boom years to 2.7% in 2011 and to 0.9% in the subsequent year . “But at least it has not got into a crisis situation like some of the other emerging economies had in a similar situation,” says Xie. “What I see now is that there is a generation of monetary policymakers in emerging economies that are doing things right. They know that financial stability is more important than growth. These people understand that if they had tried to hang onto growth then there would have been a crisis.

Today in Brazil, and also Indonesia and India, the central bankers raise interest rates as soon as there is pressure. They do this to keep the currency stable, and it means that there will not be a big crisis at the expense of growth.”

OPINION: ANDY XIE

SOUND BITE: INDIA NEEDS TO INVEST, INVEST, INVEST The recent election in India of Prime Minister Narendra Modi has boosted business confidence, and the World Bank has forecast a 6.4% growth rate for the country in 2015, up from 5.6% in 2014. Analysts, however, have warned that this will depend on strong investment, which is not something that India has always had, according to Xie. “Around the time when China was enjoying double-digit growth, Indian government officials invited me over and they asked me how they could emulate that,” he says. “I said three words: ‘Invest, invest, invest!’

“Indians are very smart,” he continues. “They have all been to Harvard. So of course, being Harvard-educated, they said, ‘But if we invest, invest, invest, there will be a financial crisis.’ I said, ’Yes, that is right, but you would have gone from the ground level to the 100th floor and the inevitable financial crisis would only take you back to the 80th floor, whereas, if you do not invest you will always be on the ground level.’”

LOOKING TO THE FUTURE In recent years, Europe’s oil and gas consumption has been falling while the USA has seen marginal growth. Asia has been driving growth but that has also been slowing.

All of which points to a tough future for the industry. Nevertheless, Xie points out that there are many steps that businesses can take to ensure that they remain competitive, from cost excellence programmes to leveraging intellectual capital to financial engineering.

And, interestingly, he suggests that the current squeeze on margins is not part of the new normal. “With Chinese people in the mood to just build, build, build, capital-intensive businesses will have to wait out this period.

It may take five years or so, but, until Chinese people slow down, their overcapacity will continue to depress margins,” he says.

“When you sit down at the dinner table in China, people are always talking about doing business. But, one day you will go to China and suddenly they will not be talking about business any more. They will talk about vacations or something else instead. And that is when the world will be normal again!”

www.shell.com/globalsolutions September 2014 The views expressed in this document are entirely those of the speaker and do not necessarily reflect the views of Shell.