Don’t blame China’s slowing demand for the fall in oil prices. Instead, look to US sanctions (and waivers) on Iran
- Neal Kimberley says lower prospects for the Chinese economy did not directly cause the recent drop in oil prices
- However, US waivers on its new Iran sanctions for China (and others) signalled the collapse of a central pillar of support, leading to fear in the market
Fans of Game of Thrones know that winter is coming, but it has arrived early for traders who have been long of oil, with many having been frozen out of positions in recent weeks as the price of Brent Crude has plummeted from a four-year high of US$86 a barrel on October 3 to a close last Friday of US$66.76.
But why has the oil price fallen so quickly and how should markets interpret it? One explanation is that expectations of lower demand for oil have weighed on its price and, as US bank BNY Mellon wrote last week, “if we’re talking falling demand, then any conversation must start with China”.
China definitely does play a role in this story but tangentially. This oil price fall is not a market judgment on China’s prospects.
Certainly, the oil cartel Opec has been cutting its forecast for demand next year. While in July, it expected demand in 2019 to rise by 1.45 million barrels per day, by this month, it had lowered that expectation to an increase of 1.29 million bpd.
Equally certainly, as a huge oil importer, China will have been on Opec’s mind. Its forecasters will have observed analysts’ notes about a potential slowing in the pace of China’s economic growth, both as a consequence of the need for the Chinese economy to deleverage but also due to uncertainties caused by the deterioration of China-US trade relations after Washington started rolling out tariffs on Chinese goods at the start of 2018.
Fear of lower future demand would explain the slide in the price of oil. And those who buy into that explanation might rationally see better value in the currencies of major oil-importing countries, such as China, India and Japan, who stand to benefit from a lower crude price and less worth in those of oil exporters.
But there’s arguably a major flaw in this argument. First off, China’s own crude oil imports hit an all-time high in October.
Moreover, if US tariffs on Chinese exports started early in 2018, and Opec had been lowering its demand forecasts since July, why did the price of oil continue to rise until early October? Brent Crude’s four-year high of US$86 on October 3 hardly suggests an oil market worrying about lower future demand.
In truth, on October 3, the oil market had every expectation that, with the United States set to impose another set of sanctions on Iran on November 5, there would be a negative effect on oil supply that would push up prices. Supply was on traders’ minds, not demand.
Yet on October 5, an anonymous US government source told Reuters that the Trump administration was in the process of considering waivers that would allow some nations to continue to purchase Iranian oil.
That was arguably the real catalyst for the oil price’s slide. Traders realised that waivers would undermine the logic of their long oil position.
Trump, using a Game of Thrones font, may have tweeted on November 2 that “sanctions are coming” but the US president might have more accurately framed that tweet as “sanctions (and waivers) are coming”. Washington provided eight countries, including China, with temporary waivers allowing them to continue to buy oil from Iran.
A central pillar of support for the oil price had collapsed, leaving a market, still very long of crude, forced to unload those positions against the previously ignored but now more pertinent backdrop of scaled-down Opec expectations for demand growth and continued speculation about China’s economic prospects. In that latter vein, Japan’s Nomura Bank’s “China monthly” on October 30 was titled “The worst is yet to come”.
Meanwhile, traders who were long of oil against the US dollar had anyway been seeing their funding costs rise amid tightening US financial conditions, while within the energy space, long oil/short natural gas positions have become increasingly untenable as unseasonably cold weather in the US has pushed US natural gas prices to levels not seen since 2014, even as the price of oil has fallen.
The impact of this intra-energy trade unwind should not be underestimated. Fear may be the real explanation of oil’s recent slide in price and, as fans of Game of Thrones will know, “fear cuts deeper than swords”. Perhaps oil’s recent price slide was just a huge trade gone bad and doesn’t represent a fundamental judgment on the future economic prospects of either China or the world.
Neal Kimberley is a commentator on macroeconomics and financial markets