The US Federal Reserve cut interest rates July 31 for the first time since the 2008 financial crisis in an effort to keep the US’s long-running economic expansion on course.
It was in many ways an unusual move given the strong labour market, but possible in the absence of significant inflationary pressures. The US Labour Department reported inflation at 1.6% for June, while the employment rate was just 3.8%.
June data for non-defence capital goods excluding aircraft was also unexpectedly strong, rising 1.9% year on year, but the Fed’s move is nonetheless defensive, indicating concerns over the domestic US economy’s resilience in the face of a global slowdown in trade.
Real GDP growth for the second quarter was 2.1% year on year, down from 3.1% in the first quarter, according to the advance estimate published July 31 by the US Bureau of Economic Analysis. Housing starts dropped 3.9% in the first half of the year and home-related retails sales were also negative, despite otherwise robust consumer spending.
Illustrating the difference between the domestic economy and the external trade environment, government spending was up 5.0%, but exports of goods and services fell by the same amount.
The Federal Reserve did not signal that the reduction was the start of a longer-term cycle of rate cutting. However, given flat imports and an overall picture of slowing growth, the need to cut interest rates is a negative indicator when it comes to oil demand.
Trade war heightens
President Donald Trump’s decision to impose further tariffs on Chinese exports to the US is of much greater significance. Washington intends to impose 10% tariffs on the remaining $300 million of Chinese goods coming to the US from September 1. The announcement prompted a 7% drop in the price of Brent, the largest one day fall in three and a half years.
China responded within a few days with an announcement from the Ministry of Commerce that Chinese companies had stopped purchases of US agricultural products. The US then named China as a currency manipulator, owing to a weakening of the RMB/$ exchange rate, which Washington believes was the result of market intervention by the state-owned People’s Bank of China. A weaker RMB aids Chinese exporters and offsets to some extent the impact of US tariffs.
In short, the trade war truce achieved at the G20 summit in June has well and truly fallen apart. The rapid resumption of hostilities by the US indicates just how far apart the two sides are on fundamental issues.
The International Energy Agency’s assessment prior to the G20 meeting was that in a worst case scenario, global oil demand could be reduced by up to 350,000 b/d one to two years after the new measures are imposed, compared with its base case. That worst case scenario is not a foregone conclusion, but the September 1 deadline provides only a short period for some kind of breakthrough, a prospect which appears unlikely.
The slow down in world trade reduces demand for transport on land and by sea as fewer goods are moved from place to place, hitting middle distillates demand in particular. This may have the unintended effect of limiting the impact of the International Maritime Organisation’s 0.5% sulphur cap on bunker fuel that comes into effect January 1, 2019.
According to impact analyses, this rule will see high sulphur fuel oil margins tank and a sharp rise in demand for, and the price of, marine diesel and low sulphur fuel oil as the refining industry struggles with a lack of desulphurisation capacity. Overall demand for crude will rise as refiners try to ramp up production of marine diesel and low sulphur fuel oil at the expense of creating a glut of high sulphur fuel oil. But, in a world of slowing demand and rising inventories, the upside impact of higher margins from low sulphur fuels may now be much less pronounced than expected.
No hot war
Back in the febrile atmosphere of the Arabian Gulf, Iran announced August 4 the seizure of a third oil products tanker. The detainment of the UK-flagged vessel Stena Impero in June came in apparent response to the UK’s detention of an Iranian crude tanker in Gibraltar, which was suspected of being on route to Syria, thereby falling foul of EU rather than US sanctions, which the EU does not support.
While the new seizure will be viewed by the shipping industry with concern, both it and the preceding seizure were of much smaller ships than the Stena Impero. The first, the MT Riah, was flying the Panamanian flag, while the latest detainee was said by Iran to be an Iraqi vessel. Both stand accused of smuggling heavily-subsidised fuel out of Iran.
As such, neither represents a serious provocation, particularly as acts of sabotage and the shooting down of drones on both sides have not resulted in a more serious escalation of what remains a tense situation.
More serious potentially is Iran’s breach of the terms of the nuclear deal from which the US withdrew last year. Although it is by no means clear that Iran wants to build a nuclear bomb, enriching uranium beyond the 3.67% limit stipulated in the Joint Comprehensive Plan of Action moves the country closer to “breakout point”, the point at which a country has enough uranium to make a single bomb.
Breaching the limit is designed to put pressure on the other signatories to the nuclear pact to find a way around US sanctions, rather than a real indication that Iran will enrich uranium to the 90% level required for weaponry, but if Iran pursues this path, the sanctions stakes become much higher.
For the moment, Iran seems willing to provoke, but not to the point of war, while the US is willing to respond commensurately. It is a dicey equilibrium, but the longer it continues, the more stable it will appear, dampening down the war risk premium in the oil price.
Meanwhile, there are signs that the ongoing Libyan conflict is beginning to impact oil production. The end of July saw force majeure declared by the country’s National Oil Corporation (NOC) at the port of Zawiya, owing to a valve closure affecting supply from the country’s largest oil field, the 300,000 b/d Sharara field, the second such incident in ten days.
Libya’s June output was 1.08 million b/d, according to secondary sources, down 40,000 b/d from May. Earlier in July, NOC reported production at its highest level in six years at 1.3 million b/d, but reports suggested it had fallen to 950,000 b/d as a result of the interruptions to supply from Sharara in early August. Libya is exempt from OPEC’s current production regime, but continued conflict and the patchwork of militia alliances on both sides leaves production vulnerable to disruption.
While geopolitical risks in both Libya and Iran should be monitored closely, it is undoubtedly the downside risks of a trade war and economic stagnation that are driving sentiment in markets.