Japan & China: Gas Field Dispute Could Ignite Crisis

Stocks held their ground overnight. Oil prices eased. So once again, it looks as if Wall Street's bulls are going to try to make a stand near the support lines of the 200-day moving averages.

Today's Analysis: China And Japan On The Brink.

The tense peace between China and Japan is likely to be tested within the next few days, if a deadline set by Japan in a dispute over natural gas reserves in the China Sea is not modified.

According to Kyodo News: "Japan will begin preparations for experimental drilling for natural gas and oil in disputed waters in the East China Sea unless Beijing provides a ["sincere"] response in about a week to Tokyo's demand that it stop explorations in the area, Economy, Trade and Industry Minister Shoichi Nakagawa said Friday."

The dispute came after the release of survey data that suggests that Chinese exploration activity may have encroached on Japanese territory. Kyodo News reported "a government geophysical survey released Friday confirmed that underground structures in two Chinese-developed natural gas fields extend into Japanese waters. The survey stopped short of confirming the existence of resources on the Japanese side, but concluded that exploration on the Chinese side ["may affect natural resources on the Japanese side."]"

The language used by Japan was fairly stern. ["We have repeatedly asked Beijing to stop natural resources development and provide data on its gas projects to Japan. Unless China gives us a sincere response, we have to proceed to the next step," Nakagawa said at a press conference. Japan will seek China's response through diplomatic channels, Nakagawa said. The Foreign Ministry will notify the Chinese Embassy in Tokyo of the government's policy, he added.]

Talk is cheap, and deeds lead to consequences. But Japan's talk is heading in an interesting direction, even if somewhat hedged. "A top Foreign Ministry official also said Friday if China refuses to provide data on the projects, Japan should take countermeasures. Nakagawa said if China offers a response in about a week, Japan will consider what steps it should take at that point," although the report suggested that Japan may start to grant exploration licenses for the disputed area to Japanese companies if the Chinese fail to deliver what Japan is requesting.

China is responding just as tersely " ["We ask that the Japanese side not undertake any activities to complicate this situation,"] Chinese Foreign Ministry spokesman Liu Jianchao said Thursday."

At the center of the dispute is what Japan calls a "median line," an area "in the Japanese exclusive economic zone in the East China Sea." China does not recognize the "median line," and claims "that its economic waters stretch further than designated by Japan." Indeed, according to the report, "A Chinese consortium is currently conducting natural gas projects on the Chinese side in an area close to the EEZ median line set by Japan in the East China Sea."

An Escalation of An Existing Trend

This situation is not new. On December 13, 2004, in this space we noted: "Japan is steadily returning to the ranks of nations with a military whose function is beyond defense of their homeland. And one of the major reasons, as cited by the country's official policy is the increased global presence of China. This creates a whole new layer of potential friction in Asia, where North Korea, China, and Russian influences are still significant, and where much remains unresolved on multiple levels."

In that report we noted, based on multiple reports, that Japan's about turn on its re-arming was likely to lead to a renewed arms race in the region.

We also wrote, at that time: "This is a complex situation with the potential for large amounts of trouble if the right spark appears."

Scenario For Trouble Continues To Unfold

In multiple articles, we have put forth what we believe is overwhelming evidence that although China's economic growth is credible, it is simultaneously dangerous.

An underreported, but persistent dynamic in China is the presence of social unrest in several areas of the country, where the wealth effect has not been delivered by the government. This is one of the main reasons that China continues to expand its influence globally, in order to deliver something to as many people as possible, and prevent a major rebellion.

At the same time, Japan's economy continues to wallow in the after effects of the 1990's Depression, and the lackluster recovery thereafter.

In essence we have two countries where bad economic policy is being magnified by their own internal politics, and the consequences of bad, long term, economic policy.

As history shows, countries that find themselves in that sort of position, look for something to unify the population.

A tried and true unifier is usually a war, or at least a situation that takes the country to the brink of war.

In other words, there is no better cure for a rebellion, and or a recession than a good fight with a traditional enemy.

China and Japan, on many levels fit the bill quite well.

Oil Market Summary And Outlook: Analyst Calls For $28 Oil. Stocks Fade In Late Monday Trading.

Market Analyst Tim Evans of IFR Energy Services told the Associated Press that he expects crude oil prices to fall to $28 per barrel this summer. Evans is obviously at the opposite end of Goldman Sachs, who last week predicted oil to rise to $105 per barrel, but did not give a specific time frame for the development.

Evans, laughingly describing himself as being on the "lunatic fringe," makes some valid points. According to AP, his rationale is as follows: "today's crude oil prices above $50 a barrel reflect nothing more than a market bubble fed by speculation and unwarranted fear." And his opinion is fairly well summarized by the following: "the world's oil supply is sufficient to meet demand, that motorists will soon show that they're not willing to pay any price for gasoline, and that the market is unreasonably receptive to worst-case-scenario thinking."

Prices eased slightly overnight, with crude trading below $57 per barrel in electronic pre U.S. action. Energy stocks rallied for most of the day on Monday but reversed course at the end, something you don't like to see if you're bullish on the sector.

Supply data is out tomorrow. If the recent trend remains in place, we'll continue to see a buildup in crude supplies, and declines in gasoline, and heating oil, as the refinery bottleneck continues to add to the situation.

We tend to agree, at least in principle with Evans, and have noted so in this space many times. Oil prices will come down at some point, although it is hard to predict when.

At the current time, we are again noticing that crude made new highs last week and that oil stocks did not confirm them, meaning that once again we are seeing that old technical divergence appear. We like to see oil stocks lead the price of crude, or at least confirm new highs in the commodity.

To be sure, this remains a bull market in oil until proven otherwise, given the fact that crude futures recently made new all time highs, and that key support levels, such as the 50 day moving average for the June contract remain intact.

Investors should remain wary of the oil market, and should use extreme caution in any exposure there.

The Philadelphia Oil Service Index (OSX) looks better than XOI, and may still to challenge its recent highs near 146. OSX is above its 20 and 50 day moving averages. Volatility will likely increase here in the next few days. For more details on trading the energy sector visit our energy timing page, featuring our highly effective OIH timing model and our Top Ten Energy Stock List.

The Amex Oil Index (XOI) has made three lower highs and an equal number of lower lows in price since topping out in February, despite a series of dramatic new highs in the commodity. This is a sign that the oil market may be trying to make a top. The scenario would change if XOI took out the old high near 893.

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