OPEC watches the US-China trade war with bated breath

China’s importance to global oil demand and thus, to oil-producing-dependent economies, cannot be overstated. It is the largest crude oil importer in the world on both a net and gross basis.

It has been the largest oil demand growth market for nearly two decades and last year accounted for more than 40 percent of global oil demand growth.

{mosads}Since an oil price collapse in 2014, sustained growth in Chinese oil demand has played an important role in stabilizing markets, alongside factors on the supply side, including the Saudi-Russian-led production cuts and faltering Venezuelan production that often get more attention.

Now that prices are 50-percent higher than a year ago, the potential for downward pressure on Chinese oil demand has raised concerns for global oil producers, particularly in the Middle East.

While data quality issues cloud oil demand growth forecasts with respect to China, under business-as-usual conditions, oil demand in the country can be expected to grow solidly for the remainder of 2018 and throughout 2019, albeit at a slower rate to that in 2017 (primarily because of slower economic growth and in part due to fuel efficiency gains).

The International Energy Agency (IEA) forecasts demand growth to reach 495 thousand barrels per day (b/d) this year and 420 thousand b/d in 2019.

At the same time, Chinese oil production is expected to decline by approximately 100,000 b/d both this year and next, meaning that net imports will reach 9.3 million b/d for 2018 and 9.8 million b/d for 2019.

While these numbers represent significant levels of growth in demand, the rate of the increase is beginning to decline and may be further reduced if prices continue to rise and if trade tensions between the United States and China persist.

Higher oil prices can affect China’s level of demand for the commodity in several ways, some of which can play out more immediately than others. One factor that could play out immediately relates to the program to build up its Strategic Petroleum Reserve (SPR).

As of mid-2017, China held more than 276 million barrels in strategic reserves, with a target to build to 500 million barrels. China took advantage of low oil prices over the course of the past few years to bolster these stockpiles, importing more than 200,000 b/d between mid-2014 to mid-2016 for that purpose.

With higher prices setting in, China may well move to curb its strategic stock purchases, which are estimated to account for approximately 100,000 b/d of demand. In the long run, higher oil prices can put a drag on economic growth rates and in turn dampen oil demand.

According to Oxford Economics’ Global Economic Model, a 1-percent oil price increase leads GDP to fall by about 0.02 percent in China.

Other dynamics that can play out over the longer run relate to price elasticities of demand, whereby a sustained period of higher prices could for example accelerate the rate of demand for electric vehicles, along with the pace at which initiatives are deployed by the government to curb oil demand growth.

The most significant threat to Chinese oil demand at the moment, however, relates to the potential impacts of a trade war between China and the United States. These risks have significantly increased recently upon the introduction of 25-percent tariffs on approximately $50 billion worth of Chinese goods by the United States and with China responding in kind.

The U.S. administration is considering expanding these tariffs to an additional $200 billion worth of goods, while President Trump has warned that a further $267 billion lies in waiting beyond that. The uptake of these measures will adversely affect global economic growth and thus oil demand.

This takes form both through a reduction in bunker fuel and diesel demand, which are used for the transportation of goods, but also possibly by impacting the trade of oil and oil-derived products.

The Organization of the Petroleum Exporting Countries (OPEC) estimates that a trade war between the United States and China could reduce global oil demand from their base case by up to 0.11 million b/d in 2018 and up to 0.35 million b/d in 2019.

China is already showing some signs of economic weakness, possibly as a result of the trade tensions, with the Caixin China Manufacturing Purchasing Managers’ Index falling from 50.8 in July to 50.6 in August, its lowest level since November 2017.

Chinese customs data indicates significantly lower demand for crude imports in June (8.4 million b/d) and weak growth in July to reach 8.5 million b/d, well below previous highs reached in April 2018 of 9.6 million b/d.

While one cannot discount the chances that any trade disruption could disappear as fast as it mounted in the first place, if it continues upon the current trajectory, a significant reduction in China’s oil demand growth rate can be expected, with its export-dependent economy suffering severely under the tariffs.

Chinese oil demand growth has played an important role in the rebalancing of the oil market, helping to increase oil prices.

However, with the supply side of the market looking increasingly uncertain as to where it will stand, any softening in demand from China could put a bit of pressure on producers in the Middle East, which are heavily reliant on this market for their exports.

Weaker demand from China could also affect the overall balance of the market. OPEC production volumes have continued to increase since the relaxing of the production cuts in June.

At current levels, Organization for Economic Cooperation and Development (OECD) commercial oil inventories are forecast to build again starting in early 2019. As such, any demand softening could play a role in helping to build a surplus in inventories, which the OPEC cohort originally worked so hard to vacate.

Andrew Stanley is an associate fellow with the Center for Strategic & International Studies Energy and National Security Program.