Robert Feldman of Morgan Stanley: Oil and Water, Japan and China

Oil and Water, Japan and China
Robert Feldman (Tokyo)

No, this piece is not about how Japan and China do not get along politically. Rather, it is indeed about oil and water — or more precisely about how the competition for resources will shape the world in which Japan and China interact over the next decades. This piece is inspired by a recent book by Michael Klare entitled Resource Wars (Owl Books, 2001). In the book, Professor Klare makes the important (but also somewhat obvious) point that the combination of geography, economics, and politics will create intense competition for scarce resources, especially oil and water.

How will Japan and China interact in this world? Are they competitors or allies? Will the competition be diplomatic, negotiated, and peaceful, or will it be military?

The answer depends on the specific resource involved, and the geography (and politics) of the resource. However, fortunately, the details suggest that Japan and China (along with the United States) have much more to gain by cooperation than by competition, especially military competition. This conclusion is clearly good news for financial markets. Even better news is the opportunities that joint development will hold for business. Industries of particular interest include plant engineering and suppliers for energy development projects and trading companies or storage facility providers for agricultural trade in the region.

Oil

Most oil analysts are now convinced that the world does face high oil prices for at least a few years, even if speculative excess and weather-related distortions abate. There is virtually no spare capacity to produce more oil, but global demand will continue to increase. So the equilibrium price will be higher. The question for all countries now is how to find new energy sources and to promote conservation.

For Japan and China, the closest potential sources of new energy are oil from the South China Sea, and oil and/or natural gas from Siberia. In light of competing claims to exploitation rights, the South China oil will be the most contentious. China has claimed vast stretches of the South China Sea as an exclusive economic zone, while other countries do the same. So far, military conflict has been limited. The only direct confrontation between Japan and China concerns the Senkaku (Diaoyu) Islands, where nationalistic groups (from both Taiwan and China) have tried to occupy the islands. The incidents so far have been handled deftly, diplomatically, and with little disruption by the Chinese and Japanese governments — which have many more important problems (such as North Korean nuclear weapons) to handle.

The South China Sea issue for Japan involves two separate questions: passthrough access to sealanes bringing energy from the Middle East, and exploitation of resources that are believed to lie under the ocean floor. The passthrough question is both military and economic. Unsure of how China and other nations will resolve the issue of economic rights, Japan is rightly worried that sealanes could be disrupted. Hence, some military presence is needed. However, to the extent that China and Japan can reduce the need for such military protection of the sealanes, both countries will benefit. (The same is true of the US, which will continue to have a role in defending Japan.) The balance of methodology for dealing with the sealane issue is likely to remain firmly diplomatic and legal, rather than military.

The exploitation issue is harder, because of the many competing claims and lack of clarity in international maritime law on how to resolve the claims. So long as the claims are unresolved, there is very little likelihood that major companies would invest any significant amounts in resource exploitation. Hence, all parties have an interest in creating a stable legal environment for development. The risk is that energy prices climb high enough, and potential users of energy become desperate enough, to occupy territory militarily. I doubt that energy prices could trigger such action, because the economic losses from unilateralism would likely outweigh any benefits. The challenge for countries in the region, therefore, is to work out a rights-sharing arrangement as soon as possible. Oil at $50/bbl is certainly an incentive to cooperate.

Other oil projects are more straightforward. Siberian exploitation will involve negotiation with Russia, and with countries through which pipelines might pass. Ironically, this factor might aid a solution to the problem of nuclear North Korea. A pipeline passing through North Korea could pay access fees to that country in the form of a portion of the energy that passes through, thus providing effective aid to North Korea, and obviating the need for nuclear facilities — the justification for a nuclear program.

Farther afield, China has an interest in building pipelines from Central Asian countries to serve western China, but Japan has little interest in such projects, except as a potential investor or provider of equipment. Such projects would benefit Japan to the extent that they remove pressure on global oil prices.

My reading of the oil situation is that both Japan and China view economic and political stability at home as requiring a cooperative solution to the oil / energy problem. Neither country has either the resources or the military power to pursue a unilateral solution. Hence, there appears to be a bright future for Japan-China cooperation in the energy field.

Water

The other major source of potential conflict that Mr. Klare discusses is water. In particular, he focuses on the scarcity of water, and control over the Nile, Tigris-Euphrates, and Indus river valleys. Obviously, none of these issues has any direct relation to either Japan or China (except to the limited extent that the Indus initially arises in western Tibet). But water is an issue, especially for China. As living standards rise, China will need more fresh water and the products thereof, but sources are limited. Moreover, as my colleague Andy Xie points out, agricultural land in China is under pressure from industrial development projects. How can China raise living standards when water and land are becoming scarcer?

The answer is to import the products that require land and water. Already, China is a huge importer of agricultural products from the US. However, as water becomes scarcer in the US as well, alternatives must be found. Japan is a good candidate. Indeed, water is the one natural resource that Japan has in abundance. Moreover, as Japan's population ages, it will require less food. In addition, the inefficiencies of Japanese agriculture suggest that much improvement in output is possible. Already, Japan supplies limited amounts of high-grade rice to some Chinese cities as a luxury item. The factor endowments suggest that there is more such trade in Japan's and China's futures.

Other Resources

There are many other resources in which Japan and China have common interests in ensuring stable supply. Among these are minerals from Africa, fish from the oceans, and uranium in particular — a source of energy that may well come back into fashion as high oil prices persist. None of these resource issues can be settled in a unilateral way. Rather, China and Japan must cooperate in creating a strong Asian voice for peaceful exploitation. It is in this context that the proposals to re-organize the United Nations’ decision-making structure are key. So are regional initiatives, such as Japan-ASEAN cooperation and regional Free Trade Agreements.

Investment Implications

Investors in Japan will likely be paying more attention to the energy and water issues over the next few years. Japanese companies stand to benefit from new energy projects, not only as suppliers of machinery and materials (e.g., high-grade seamless pipe) but also as designers and implementers of projects. While currently still troubled by balance sheet difficulties and cash flow problems, the Japanese plant engineering companies have much expertise in these areas. Moreover, transportation of energy, particularly natural gas, will require increased fleets of LNG tankers and port facilities. The latter must be constructed some distance from large urban areas, in order to ensure safety, and thus some rather large projects could become necessary.

The implications of the water issue are somewhat different. Japan has no major agribusiness sector, but the imperatives of food supply for the region suggest that such firms could emerge. For this to happen, however, major deregulation would be needed, particularly an expansion of corporate ownership of farmland. In addition, the efficiency of distribution of agricultural products needs work. These inefficiencies are the raw material of business opportunities. Ironically, such a turn of events would reverse the trade flows of the last decade, in which China has become a major supplier of fresh vegetables to Japan. However, as China's needs grow, and as the resources for producing such crops in China dwindle, Japan could help fill the gap, first by replacing China's exports to Japan, and then by exporting to China itself. Trading companies are likely to be major beneficiaries of trade pattern changes, in light of their expertise in project investments and in distribution. Moreover, as agricultural trade grows in the region, the need for storage facilities could help the manufacturers of machinery for this sector.