The Fuse

Trade War Threatens Oil Markets

by Nick Cunningham | May 21, 2019

The U.S. recently decided to hike tariffs on $250 billion worth of Chinese imports from 10 to 25 percent. In response, China increased tariffs by the same percentage, although on a smaller volume of imports from the U.S.

Oil prices have been inching up because of major supply outages in Venezuela and Iran, and geopolitical instability threatens an already tight oil market. But crude oil would arguably be much more expensive if not for the U.S.-China trade war. The danger is that the trade war tips the global economy into a deeper downturn.

Higher tariffs directly impact energy flows.

Tariffs a drag on oil and gas
Higher tariffs directly impact energy flows. China refrained from slapping tariffs on U.S. crude, but it did hike tariffs from 10 to 25 percent on U.S. LNG. China is the largest source of LNG demand growth, and by 2025 it will be importing 95 million tonnes per annum (mtpa), up from 53 mtpa in 2018, according to Rystad Energy. That will be enough to make it the largest importer of LNG in the world. As a result, tariffs on U.S. LNG are significant.

To a large degree, the tariffs are manageable for LNG exporters because a significant portion of their shipments are under contract and spot cargoes can be rerouted elsewhere. Nevertheless, the initial 10 percent tariff reduced U.S. LNG exports to China. But the tariffs present a larger danger to proposed LNG export projects that have not yet received final investment decisions. The latest round of tariffs by China should give developers and investors pause. “[T]here will be a reluctance to signing new deals with US projects as long as this trade war persists,” Sindre Knutsson, Senior Analyst at Rystad Energy’s Gas Markets team, said in a statement. “For example, Cheniere and Sinopec agreed late last year on a 20-year deal that would supply 2 million tpa of LNG to China starting in 2023. This deal could have been signed once the trade tensions were resolved, but due to the heightened tensions this has not happened.”

A series of other proposed projects outside the U.S. currently on the drawing board would get a leg up now that U.S. LNG is under Chinese tariffs, especially if the trade war drags on.

Protectionism could cut into oil demand at a time when demand was already showing signs of strain.

More broadly, however, the trade war could act as a drag on global markets more generally. Protectionism could cut into oil demand at a time when demand was already showing signs of strain. In the first quarter of 2019, oil demand grew by 640,000 barrels per day (b/d) compared to the same period a year earlier, according to the International Energy Agency (IEA). Only a month ago, however, the agency expected that figure would end up being 1 million barrels per day (Mb/d). As a result of the downward revision, the IEA said that supply exceeded demand in the first quarter by about 0.7 Mb/d, much higher than initially expected.

However, the IEA expects that dwindling output in Iran and Venezuela could tighten up the market. The 0.7 Mb/d surplus in the first quarter could flip into a deficit of a similar size in the second quarter, the agency said. Also, demand should firm up, the agency believes.

“The general assumption remains that, after a period of weakness at the end of 2018 and in 1Q19, world economic activity is likely to pick up in 2H19 and into 2020. Patient monetary policies and fiscal stimulus should contribute to support growth,” the IEA said. “Rising trade tensions, however, represent the main threat to the currently fragile rebound.”

Trade war adds gloom to darkening outlook
The IEA downgraded its demand estimate for 2019 by 90,000 b/d, but stuck to a rather robust estimate of 1.3 Mb/d. The downward revision was rather minor given the threat that the U.S.-China trade war presents, especially since it shows no signs of abating. Higher tariffs could slow growth at a time when many economies are showing signs of trouble.

A series of emerging markets are reporting weak economic data, including in India, Turkey, Argentina and Brazil. Global auto sales are also cooling, with a significant contraction underway in China, the world’s largest auto market. Car sales in China fell 11.3 percent in the first quarter, year-on-year. Global manufacturing data also appears weak. The U.S. Federal Reserve called off further rate hikes earlier this year in response to the darkening economic outlook.

“Escalating trade conflicts and dangerous financial vulnerabilities threaten a new weakening of activity by undermining investment and confidence worldwide,” the OECD said in its latest Economic Outlook. The OECD sees global GDP expanding by 3.2 percent this year, down from 3.5 percent in 2018. Global trade is expected to expand at its slowest rate in a decade, and the trade war is “hurting manufacturing, disrupting global value chains and generating significant uncertainty,” the report said.

Bank of America noted that crude oil demand growth averaged just 680,000 b/d in the last two quarters, down sharply from the roughly 1.46 Mb/d growth rate over the last five years. “[R]ecent data points to a very meaningful slowdown relative to recent historical trends,” the investment bank said. Worse, the first round of tariffs was mostly “absorbed by a combination of margin compression and foreign exchange rate realignments,” the investment bank said. The latest round of tariffs, now at 25 percent, will increasingly be passed on to consumers. “[G]loomier sentiment has taken hold in some pockets of the global economy,” Bank of America concluded.

A third round of escalating tariffs is possible. The Trump administration has threatened tariffs on another $300 billion of Chinese imports, which would cover nearly all imports from China. If the U.S. follows through on that threat, the world could fall into economic recession, Morgan Stanley said.

As a result, crude oil is trapped between supply outages on the one hand, and economic pitfalls and the trade war on the other. “In our view, the global business cycle is at a key junction. Weakness in manufacturing may drag down services if trade wars eventually hurt consumer sentiment. In a global downturn, Brent could slip to $50/bbl,” Bank of America Merrill Lynch wrote in a note to clients on May 16. “On the other hand, under a US-China deal scenario, business confidence may return with a vengeance, resulting in a weaker USD and stronger global growth. If a cyclical global demand upturn coincides with an IMO2020 boost, Brent crude oil prices could spike to $90/bbl.”

For now, with both U.S. and China digging in, the prospect of the trade war persisting appears more likely than a quick resolution.