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Jacob Hess

Jacob Hess

As a student at Emory University, Jacob studies economics, mathematics, and psychology while engaging in personal studies of the financial markets. His particular interest in…

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Falling Chinese Demand Could Intensify The Oil War

The Chinese slowdown did more than drag down its own economy, it singlehandedly created financial tremors throughout the global financial markets. With consistent growth rates well over 6 percent, China's economic health is an integral part of global expansion.

But just last year, investors saw the disintegration of billions of dollars’ worth of wealth on the Asian giant's stock market. The globalized economy experienced economic withdrawals with lagging Chinese demand, a substance to which both foreign and local industries have become addicted. It goes without saying that industrial and manufacturing demand in the Chinese economy acts as a relevant indicator of the world's financial condition, similar to the status of the United States. For that reason, investors have no choice but to realize the implications that can come from changes in demand for Chinese goods, services, and capital.

A country's stock market is often a leading indicator of its economic performance. In China, two dramatic corrections occurred in the middle of 2015 which translated to the weakness that would infect the global economy. From its peak last year, the Shanghai CSO 300 Industrial Index has lost over 50 percent of its value in a downtrend that has depressed sentiment surrounding the industrial and manufacturing sectors in China. The downtrend has softened but continues to devalue large-cap industrial shares approaching values seen in mid-to-late 2014. As far as projections go, the stock market appears to be an indicator of a contraction in demand. Investors looking to pump capital back into these Chinese firms need to consider the bubble-like symptoms that caused four freefalls in the past year. Related: Iran Hits Saudis Where It Hurts, Offers Discounts On Asian Crude

The China Caixin Manufacturing PMI is one of the most watched industrial economic indicators for domestic and global demand trends. The index tracks the monthly growth of the manufacturing sector, one of the largest components of China's GDP. Readings above 50 translate to expansion while readings below 50 represent contraction. February 2015 was the last month where an expansion was reported before the drop that occurred later in the year. Just after the major correction in August 2015, the September reading was recorded at its lowest point, 47.0. From there, the contractions have been slowly shrinking to just below 50 in March 2016.

The worst of the losses look to be over with a trough most likely formed in late 2015. The next milestone for recovery will be getting the PMI back into positive growth territory. Demand will only fully come back online when the levels of mid-2014 are approached. But, at the very least, the worst could be over, as the corrections have successfully repriced the stock market in relation to the country's manufacturing strength.

When the Chinese manufacturing and industrial sectors are strong, their consumption of raw materials, machinery, and just about anything else is equally as robust. China is highly dependent on heavy industry, which made up 40 percent of the economy in 2014. As the slowdown set in, businesses started to import less. In April 2016, Chinese imports dropped by 10.9 percent to $127.2 billion, a 30.6 percent slide from the March 2013 peak of $183.1 billion. Moreover, imports may never recover to their peak levels. The Chinese economy is undergoing a transformation, and the emergence of a service sector is allowing China to shift away from a reliance on heavy industry. For global exporters of commodities and industrial materials, the shrinking of the world's largest source of demand is bad news. Related: EPA Launches New Methane Rules For Oil And Gas

Nowhere is this more evident than in the Chinese energy sector, as crude oil accounts for about 6 percent of total imports. According to EIA data, members of OPEC already account for 58 percent of China's oil supply with its leader, Saudi Arabia, the highest at 16 percent. Saudi Arabia’s revenues have plunged because of low oil prices, forcing the Saudi government to cut spending on social programs.

Now, the slowdown in Chinese demand as it builds up its service sector, combined with a global push towards renewable energy, could further threaten the already fragile levels of Chinese oil consumption. On top of that, China has pushed to diversify its sources of imports, another challenge to Middle East suppliers. China has already exchanged the volatile supply of Sudan, Iran, and Syria for deals with its neighbor, Russia. More shifts could be due in the near future and here's who may be affected:

Saudi Arabia, Angola, and Oman are all countries that supply at least 10 percent of China's crude oil. But recently, the Wall Street Journal reports that Russia has overtaken the trio to China’s top supplier. In the first quarter of 2016, Saudi Arabia's exports to China have only increased by 7.3 percent despite low oil prices, which should encourage larger increases in consumption. In a world of abundant supply, OPEC members will fight each other for market share in China, especially if Iranian capacity increases rapidly and a cheap energy environment settles in for the long run. The disinterest of the cartel's biggest customer could mean a more competitive market, or worse, the disintegration of OPEC. Related: Where Will Halliburton And Baker Hughes Go From Here?

Russia has had the advantage of being on good terms with China while they shift their supply chains to more secure channels. Deals like the $400 billion agreement between the Chinese government and Russia's Gazprom have given their neighbor preferred access to China. As Saudi exports fell, Russia logged a 42 percent increase in crude oil shipments to China in the same period. Russia has seduced Chinese customers with discounted crude as well as deals done in yuan, whereas most of global oil deals are conducted in dollars. The new partnership has increased tension present in the rivalry between OPEC and non-OPEC members. The shift in Chinese imports might convince Saudi Arabia and its peers to increase production, a threat already used by Saudi crown prince bin Salman. But has Russia won this "race" before it began? According to the EIA, Russia and China have signed a deal to send "up to 800,000 b/d of crude oil by 2018." With the country securing more demand for its enormous oil and natural gas stocks, they might be in prime position to benefit from a stabilization, or maybe a recovery, in energy prices.

The United States is in a unique position in this changing market. With shale production spurring a renaissance in domestic supply, the world's second largest oil importer now has options on the supply side. Energy independence (no imports) may never be in the equation, but the U.S. could begin to balance their energy trade deficit with the ban on exports lifted. However, the shrinking discount between WTI and Brent means that it becomes cheaper to import oil. Also, weak Chinese demand is keeping oil prices low, and the shale revolution is withering away as a result.

The days of global reliance on Chinese demand are soon coming to end as seen by the decline in growth rate, decline in imports, and increase in service sector strength. The implications have already been great as stock markets across the developed world fell into peril when China's GDP growth rate fell below 7 percent.

Withdrawal symptoms may last for a while until a recovery in demand alleviates some pressure. But global financial markets will have to adjust to a developed China, and as this "new normal" sets in, it will mean softer demand for commodities. China’s slowing demand for oil will lead to heightened competition for suppliers. For now, it appears that OPEC’s loss is Russia’s gain. The energy players and other foreign businesses that once relied on China's robust growth will no longer be able to depend on its expanding demand. A new group of emerging economies will have to step in. Who will they be?

By Jacob Hess for Oilprice.com


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