Luckily, there was no accident, and no navy presence from either side. But that was the extent of the silver lining, as this opaque and high-stakes game of brinkmanship continues to play out between the worlds second and third biggest economies.

U.S. Assistant Secretary of State to Asia Kurt M. Campbell emphasized this point recently in a trip to the region. On Feb. 26, he told The Australian newspaper, In four years as assistant secretary Ive faced many difficult diplomatic situations, but none more difficult than this. Ive rarely seen diplomats on both sides [Japan and China] more white-knuckled, and on both sides the sense that no retreat or compromise is possible.

The good news is that the economic integration and interdependency of both countries means that Tokyo and Beijing have powerful incentives to remain economically warm even if politically cold. Whether nationalism, political jockeying and a dynamic security environment hijack this relationship remains to be seen. However, it is clear that neither side wants this end.

LubesnGreases recently discussed the bilateral economic relationship with lubricant company officials in Japan, and heard two key points: First, corporate Japan (not just the petroleum industry) is extremely nervous about the potential for a greater strain in the Sino-Japanese relationship. And second, most Japan-based lubricant companies have no intention – at least stated – to abandon the Chinese market or even reduce investments there. At least for now the opportunities in China outweigh the political risk.

Demand Still Rules

The Chinese lubricant market remains dominated by domestic and non-Japanese foreign companies. According to industry research from the Kline Group, Chinas lubricants market is cornered by national companies Petrochina and Sinopec, which in 2011 held 21 percent and 19 percent shares, respectively. The leading foreign investors include Shell (7 percent), Exxon -Mobil (5 percent) and BP Global (3 percent). Japanese petroleum companies such as JX Nippon Energy, Idemitsu Kosan and Mitsui Chemicals all have shares under 3 percent.

Despite this, China continues to be a target for Japanese petroleum companies because of the cheaper operating costs and sustained levels of demand in both the automotive and industrial markets. JX Nippon set up a venture in 2005 with Sinopec to form the Nippon Oil (Guangzhou) Lubricants Corp. Asked by LubesnGreases whether the current political tensions between China and Japan would affect JXs lubricants strategy in China, spokesman Hayashi Suzuki remarked that there has been no change in strategy.

Regardless of the political climate, Suzuki added, business in China is still important for JX. Moreover, the companys most recent annual report noted that against a background of progress in motorization in emerging countries, substantial growth is expected in worldwide lubricants markets, especially in Asia. The company has taken steps to steadily expand its operations.

However, despite the rosy outlook, JX remains cautious about future investment in China. The companys risk profile ranks risks related to business operations in China and other East Asian countries as its second biggest risk, after access to raw materials abroad. Another (and related) risk fault line relates to currency exchange and the value of the yen to purchase overseas and run subsidiaries overseas. The yens bullish strength over the past couple of years, while problematic in other ways, has allowed Japanese companies to be more aggressive in their foreign expansion.

This luxury may be ebbing now though, as the yen has weakened significantly since the election of new Prime Minister Shinzo Abe last December. Abe has introduced a policy of quantitative easing and massive stimulus, aimed at weakening the yen to drive up Japanese exports, a theme which has traditionally dominated its economy. However there is the potential that such moves could be counter-productive and actually trigger hyperinflation (which is the opposite of Japans near deflationary situation of the last decade). Abes moves may drive down the price of the yen at first and are being welcomed by international investors, but they raise the specter of a highly indebted economy.

Idemitsu Kosan, another of Japans big petroleum companies, also acknowledged the risk of volatile demand in China, and spokesman Miki Shimizu told LubesnGreases that despite demand for petro-chemicals in China increasing recently, there remains the potential that demand will eventually decline as a result of an economic slow-down or other factors. Indeed, Idemitsu admitted in its annual report (for fiscal year ended March 31, 2012) that demand for its petrochemical products had dropped as a result of sluggish demand in China, the floods in Thailand, and the effect of the Great East Japan Earthquake in 2011. It repeated the leitmotif of sluggish demand from China in a more recent financial report, for the nine months ending Dec. 31, 2012.

Still, Idemitsu remains a key player in China, maintaining three branches in the country (Shanghai, Tianjin and Guangzhou) and producing a range of automotive and industrial lubricants at six Chinese plants. Sales continue to be successful in the country and Idemitsu has targeted mainland China as one of five core markets in Asia Pacific (along with Singapore, Malaysia, Hong Kong and Australia). Currently, 8 percent to 9 percent of the companys sales come from this region.

Mitsui Chemicals is also invested heavily in China. Mitsui has more than 500 employees based in the country – its highest head count after Japan, Thailand and the United States. Moreover, 34 percent of its sales now go to China, com-pared with 46 percent in the rest of Asia. In 2011, Mitsui decided to construct a plant there to produce phenol and polymers through a joint venture with Sinopec, Chinas largest chemical company. Commercial operations are slated to start in 2014 and produce 75,000 metric tons per year. This was an easy decision in part, as Chinas automobile production is growing at a rate 7 percent per year and ris-ing. Vehicle production in Japan for comparison is decreasing by 4 percent annually.

Mitsui, JX Nippon and Idemitsu Kosan remain fixated on demand from China – which makes sense – and have deflected the idea that it might be time to look elsewhere, due to politics.

The Economic Ties that Bind

Discussions with lubricant officials in Japan make it clear that they are uneasy about the sour turn in relations between Japan and China. However there is a belief and hope that this does not spill over into a greater trade war. Beijing and Tokyo are deeply integrated with each other economically and neither side benefits from a prolonged conflict. Indeed, Abe said as much during a Feb. 28 policy speech in the Japanese Diet: My doors of dialogue are always open to China and it is one of Japans most important bilateral partners. Hundreds of millions yens worth of Japanese corporate investment fled China after the riots last fall, in which Chinese demonstrators attacked Japan-owned businesses there. This political conflict hurts the economies of both countries.

Japans economy is often underrated when compared with China (which surged past Japan last year to become the worlds second largest economy) and South Korea (with has inked significant foreign trade agreements with the United States and the European Union). However, Tokyo has taken a proactive approach in recent years, signing economic partnership agreements with India, Singapore, Malaysia, Thailand, Indonesia, Vietnam, Brunei and the Philippines. Japan also is in current EPA negotiations with regional heavyweights South Korea and Australia.

There is a growing narrative in the world media that Japan is in permanent decline and cannot compete with Asias young and dynamic markets. This is an overly simplistic view, as Japan expert Eamonn Fingleton wrote in the New York Times in January 2012. By many measures, the Japanese economy has done very well during the so-called lost decades, which started with a stock market crash in January 1990, he asserted. By some of the most important measures, it has done a lot better than the United States.

While Japan has significant demographic (low birth rate, high percent of pensioners) and economic (high debt, low growth) pressures, the country and its companies continue to innovate and be an important part of the supply chain in Asia. Chinas economy relies primarily on manufacturing and – despite its sparring with Japan – on foreign direct investment from Tokyo and niche technologies from Japan to complete its exports.

Similarly, as the Association of South East Asian Nations (ASEAN) grows, it will continue to rely on Japan as a secure player in the global supply chain. As economist Gillian Tett argued in a Financial Times piece, Japan still plays an important role in some manufacturing supply chains, most notably in the auto and electronics sectors. The country, for example, produces about 30 per cent of the worlds flash memory [used in electronic cameras and smartphones] and around 15 per cent of the D-Ram memory [used in computers].

ASEAN will also stay close to Japan for geopolitical reasons and to hedge against China. It will be an immense challenge however for Abe and his government to leverage this role and position Japan for a prosperous and secure future. Abes intention to separate politics from economics with regard to Japans territorial disputes is supported by business leaders and foreign politicians alike, but maintaining this course could be increasingly challenging over the coming months.

For now, it seems that Japans petroleum companies are taking a wait and see approach to the rift and not making any sweeping or rash decisions. And hoping that incidents like Feb. 18 do not reoccur.