Jan 07, 2015 05:17 PM

Seize the Reform Opportunity in Falling Oil Prices

In the last weeks of 2014, the plunge in oil prices triggered a shocking tumble of Russia's ruble. Meanwhile, China, the world's largest net importer of oil, held a work conference over the last weekend of December that outlined strategy on energy security.

The meeting called for the development of clean energy, a reduction in reliance on fossil fuels and the protection of oil and gas supplies. It pledged a revolution to improve energy efficiency in both demand and supply, through technological advances and better cooperation between global powers.

These measures are all commendable, but China's most urgent task is to seize the opportunity provided by current low prices to deepen the reform of state-owned enterprises (SOEs), upgrade the energy industry and promote the development of new energies.

The fall in crude oil prices will not only help to lower production costs and spur consumption in China, but more importantly it will also boost reforms. When prices were high, investment inefficiencies and the many problems associated with SOEs were easily covered up. But these will be gradually exposed when prices drop.

Of course, the low prices may also deter investments in new energies, thus becoming a drag on efforts to change the energy mix. To address such problems, the government must craft effective, comprehensive policies.

Like the Chinese economy, the global oil market is also adjusting to a "new normal": the fall in oil prices may be no short-term blip but a long-term trend. In terms of supply, the rise of the non-OPEC producers – particularly the United States, with its newly accessible reserves of shale oil and gas extracted through fracking – has gradually weakened the cartel's control.

In terms of demand, the state of the global economy is one reason prices have dropped. Since 2003, oil prices have largely tracked the fluctuations of the global economy. Notwithstanding short-term rises in price from time to time – due to a surge in geopolitical tensions, for example – the global oil market may well have become a buyers' market.

How long low prices will persist will depend on the timing and nature of the next global boom. China must not stand by amid the energy shake-up.

First, it must loosen the stranglehold of state-owned monopolies in the sector. Although oil accounts for less than one-fifth of China's total energy consumption, it has remained a key consideration in the country's energy strategy over the past two decades. Too often, industry directions are decided and foreign policy decisions made on the basis of ensuring a secure supply.

Unsurprisingly, the outsized political and economic influence of the oil sector has allowed corruption to thrive. Its restructuring must be a focus in the upcoming reform of SOEs, starting with more stringent oversight.

Within the sector, other problems abound. Excess capacity is a major problem in the downstream petrochemical industry, yet fears of being made redundant have actually driven some companies into an aggressive expansion, thus worsening the problem of overcapacity. And while falling crude prices should have benefitted the industry by lowering production costs, the reality is the opposite. The monopoly of the major oil importers means prices remain sticky.

Thus, reform is urgently needed for both the upstream and downstream industries. Upstream, competition must be introduced to weed out the unfit, to arrest the decline in profits; downstream, the markets must be opened up as soon as the upstream monopolies have been broken up.

Second, Chinese efforts to reduce energy consumption, cut emissions and develop clean energies must not flag. To date, the country has relied on encouraging private investment to develop this industry. But in an era of low oil prices, investors will face even greater uncertainty and come under crushing financial pressure.

To help, the government must go beyond merely providing subsidies. It must develop a comprehensive policy framework to nurture the clean energy sector. Otherwise, the hefty investments will only be wasted. On this point, the struggling wind and solar industries provide lessons worth heeding.

Third, the energy sector must better itself to compete on the global stage. In the face of low prices and production excess, Chinese companies that have already acquired substantial overseas assets must choose its next steps wisely. They should turn their attention from unthinking expansion and rapid acquisition of assets to improving their management.

The significance of China's response to falling oil prices will go beyond a restructuring of the industry. What it does will have implications on the reform of SOEs and the country's sustainable development.

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