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Oil Crashes On New Trade War Escalation

Nick Cunningham

Oil resumed its decline on Monday after China showed signs of not backing down in the face of more tariffs from the United States.

It wasn’t just oil. Financial markets plunged on Monday. The Dow Jones Industrial Average was down more than 800 points during midday trading, off more than 3 percent. The selloff is widely seen as a continuation of the negative sentiment that took hold last week, immediately after President Trump announced a 10 percent tariff on $300 billion of Chinese imports that could take effect on September 1.

The Cboe Crude Oil Volatility Index (OVX), which measures oil price volatility, jumped by more than 20 percent since last week.

The reason that the gloom returned after a slight rebound – perhaps traders “buying on the dip” – was that China signaled every intention of pushing back against the Trump administration, not capitulating. The Chinese government reportedly asked state-owned companies to suspend purchases of agricultural products from the United States. Soybean futures for November delivery fell by 1.6 percent, although rebounded a bit, paring losses to 0.6 percent.

And on Monday, China let its currency, the yuan, to depreciate to more than 7 to 1 with the U.S. dollar, a threshold that is often cited not just as a key psychological barrier, but also one that indicates a strategic decision on behalf of Beijing to let the currency weaken in order to counter the effects of trade tariffs.

In other words, a weakening currency is more than just a defensive maneuver. It signals that China is not willing to take it on the chin in an attempt to make a deal. As such, the odds of a deal seem increasingly remote.

That’s how the financial markets interpreted the move. Economic slowdown and recession are now definitively back on the front burner in terms of top concerns for traders. “The trade war is now intensifying and it’s possible that a currency war will start as well,” Chris Zaccarelli, Chief Investment Officer for Independent Advisor Alliance, told Bloomberg. “Neither is good for the global economy and both will hurt equity markets.”

A slowdown, obviously, would have a negative impact on crude oil demand. A weaker yuan may help mitigate the impact of U.S. tariffs, but it also could cut into the purchasing power of the Chinese consumer. As such, China’s economy could take a hit.

Related: Oil Price Correction Triggers Shale Meltdown

“The US and China are the world’s two largest oil consumer countries, together accounting for roughly a third of global oil demand and half of the demand growth expected this year,” Commerzbank said in a note. “As such, an economic downturn sparked by new punitive tariffs is unlikely to leave oil demand unscathed.”

Commerzbank pointed out that while the International Energy Agency (IEA) recently kept its demand growth forecast at about 1.2 million barrels per day (mb/d), the figure – already downgraded from previous estimates – was rather optimistic and hinged on a resolution to the trade war.

As a result, it seems likely that the agency will now be forced to slash its demand estimate for 2019. “Depending on how sharply the forecast is lowered, there is a risk of an oversupply in the final quarter of this year, and of an even bigger one next year,” Commerzbank said.

At that point, OPEC+ will face a conundrum – whether to keep its current arrangement in place and risk a price crash or take on a heavier burden by cutting production even deeper.

A big uncertainty at this point is whether or not U.S. shale will live up to the heady production growth forecasts that everyone has assumed. Last week’s meltdown of energy stocks is clear evidence that the sector has decidedly fallen out of favor with Wall Street. Job cuts and spending pullbacks are spreading, and production growth has already moderated.

The oil majors are picking up where the rest of the U.S. shale sector is leaving off, so it’s not inevitable that production growth slows. But with shale drilling largely a loss-making enterprise, investors are growing wary and are demanding more caution. A heightened trade war – and consequently, lower oil prices – will only increase the pressure on drillers.

By Nick Cunningham of Oilprice.com

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