Oil prices, along with equities across the board, were dragged down on Monday over fears of a brewing trade war.
China announced $3 billion of tariffs on U.S. goods, including pork and recycled aluminum. The move came as a retaliation to the Trump administration’s 25 percent tariff on steel and aluminum imports. China’s tariff announcement on Monday sent global financial equities careening downwards, and the losses were likely magnified by President Trump’s Twitter attacks on Amazon, which sparked a selloff in tech stocks.
Fears of a global trade war are again on the rise. The worrying thing is that China’s tariff measures on Monday were somewhat narrow, and only came as retaliation to the steel/aluminum tariffs, not the $60 billion in tariffs the Trump administration announced more recently, which specifically targeted China.
Chinese officials reiterated a desire to avoid a trade war, but China might not hold its fire forever, and the government could be preparing a larger set of trade tariffs in response. In other words, there is a decent chance that the trade dispute continues to escalate.
That is bad news for oil prices. The case for oil going higher largely hinges on exceptionally strong demand scenarios for 2018. “Our latest forecast suggests that demand will grow by 1.7 million b/d in 2018, the fifth-highest this century,” WoodMac said in a recent note. A trade war would seriously upend that forecast. Related: Upstream Oil Investments Bounce Back
“The retaliation from China is concerning for energy markets,” said Michael Loewen, a commodities strategist at Scotiabank in Toronto, according to Bloomberg. “If a trade war occurs between these countries and it affects demand growth from emerging markets, that could be a big problem.”
Adding to the danger for oil prices is the fact that speculators have once again staked out an incredibly bullish position on oil futures. Hedge funds and other money managers have acquired a record in terms of net length in Brent futures, rising to 595,596 for the week ending on March 27, an increase of 34,388 from a week earlier. While that is a sign confidence in the trajectory of the oil market, it also exposes oil prices to a correction should sentiment turn bearish. As John Kemp of Reuters notes, the proportion of long to short bets has stretched to a record, exceeding 12:1.
Hedge funds and other money managers are all betting in the same direction. “That makes prices vulnerable to bad news,” Greg McKenna, chief market strategist at futures brokerage AxiTrader, told Reuters. He cited news that Russia increased production in March as an example of the type of market development that could upset the bullish sentiment and force a selloff.
Indeed, as has repeatedly occurred over the past several years, whenever investors build up positions in the futures market and take things a little too far, they tend to rush back in the other direction at the first sign of trouble. In fact, that occurred at the end of January when Brent surpassed $70 per barrel. The spike in financial volatility in early February led to an unraveling of positions and a sharp slide in oil prices. Related: The Petrodollar Isn’t Dead Yet
The danger for oil is that a possible trade war represents one such obvious threat to market sentiment. “The broader markets are struggling,” John Kilduff, a partner at Again Capital LLC, told Bloomberg. The oil market “is super long at the moment, so without a catalyst it will be hard for that length to stick around.”
This all stands in sharp contrast to a longer-term outlook for oil. Inventories are falling, OPEC is intent on keeping the production cuts through this year and into 2019, and plenty of geopolitical surprises could explode and take supply off the market. That means that there are very good reasons for why an oil price rally might occur later this year.
Yet, a trade war looms as a potential spoiler. And in the immediate future, anything that upsets bullish sentiment could lead to a price correction for oil, given all the lopsided speculative interest that could come undone.
By Nick Cunningham of Oilprice.com
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