U.S., China Trade War Puts A Lid On Oil

The oil market has suddenly gone south in recent weeks, with cracks in the global economy starting to drag down oil. The U.S.-China trade war is one of the drivers of the souring climate. But that conflict could get a lot worse in the months ahead.

The latest flashpoint is the lira crisis in Turkey, which is dragging down other currencies and sparking fears of an emerging market crisis. But the problems have been building for some time. The IEA warned last week that the oil market has been "cooling down," which was partly the result of a restoration of outages in Libya, but also a slowing of demand in the second and third quarters.

The return of some supply and the slowdown in demand has depressed prices in July and August. "Brent is thus facing its third consecutive weekly loss. WTI even looks set to be down for the seventh week running - which would be its longest losing streak in three years," Commerzbank wrote in a note.

Other negative signs have become more visible. Fuel markets are showing signs of trouble. Oil demand in Asia is slowing down. Timespreads in the oil futures market are throwing up some bearish signals.

From here, it is unclear which way we go. The outages in Iran loom, but so does a potential further knock on demand.

One main "factor to consider is that trade tensions might escalate and lead to slower economic growth, and in turn lower oil demand," the IEA warned, clearly referring to the escalating trade conflict between the U.S. and China. "If this does happen, it might dampen to some extent the impact on prices of any supply pressures."

Intriguingly, however, those two issues could soon become intertwined, whereas up until now they have mostly been separate issues. More specifically, China may defy the U.S. demand that it stop buying oil from Iran, which could heighten the tension between Washington and Beijing.

"The United States certainly hopes for full compliance by all nations in terms of not risking the threat of U.S. secondary sanctions if they continue with those transactions," Brian Hook, the U.S. point person on Iran sanctions at the State Department, said a few days ago. "We are prepared to impose secondary sanctions on other governments that continue this sort of trade with Iran." The statement was a not-very-subtle threat to Beijing: Cut imports from Iran or face U.S. sanctions. Hook was recently appointed to head the so-called Iran Action Group, which seeks to apply "maximum pressure" on Tehran.

The U.S. government has alternately said that it wants countries to cut their imports to zero while also signaling flexibility for countries that make an effort to dramatically reduce their purchases of Iranian oil. Bloomberg reported that India has considered cutting oil imports from Iran by 50 percent in exchange for a U.S. waiver on the rest.

But China has indicated that it would be unwilling to comply with Washington's demands. Thus, the Trump administration is suggesting that it would slap sanctions on China, which would amount to yet another dramatic escalation in tension between the two countries, which now spans multiple issues.

Meanwhile, the trade war is also proceeding forward as before. Tit-for-tat tariffs are showing no signs of letting up, although negotiators from both countries will meet again later this month to resume negotiations, the first direct trade talks in more than two months. It is unclear if the Trump administration will move forward with the previously announced $200 billion in tariffs before then.

If the U.S. does move forward on those punitive measures, China will be compelled to respond. Beijing has proposed tariffs on U.S. LNG next, which would force U.S. gas exporters to look to other markets. Analysts say that instead of curtailing existing exports, the bigger impact of the tariffs will be to put new U.S. LNG export terminals on ice. "There's no way in the current environment that anyone's going to be signing any deals," Neil Beveridge, senior oil analyst at Sanford C. Bernstein & Co., told the Wall Street Journal. "It's causing a big overhang on what can get done." China notably refrained from putting levies on U.S. crude earlier this month, but an escalation from here opens up all sorts of uncertainties.

In short, the U.S.-China conflict is a huge weight on the oil market, even as the potential for serious supply outages from Iran loom just over the horizon. "Although emerging market contagion and China slowdown fears seem somewhat overstated, neither fundamental nor sentiment should provide support for higher commodity prices," Julius Baer Head of Macro and Commodity Research Norbert Rücker said, according to Reuters.