In late June, BofA’s Francisco Blanch showed up on Bloomberg TV and said this:
The trade issue and the Iran issue [could] become the same issue, and that ends up creating a $30-a-barrel scenario for oil prices. You get an extra 2 million barrels from Iran and demand collapses, where do you think prices are going to go?
Blanch was describing an “uber-bearish” scenario for crude that would have been familiar to those who follow his research.
“Keep in mind that Iran has historically been China’s number 3 supplier, so recent curtailments in Iran oil imports to comply with US sanctions suggest that China is still serious about getting a trade deal done”, he wrote in a June 14 note.
Read more: One Bank’s ‘Uber-Bearish’ Oil Scenario And A ‘Worrying Asymmetry’
At the time, Blanch argued that additional escalations in the trade war could deep-six demand for crude by weighing further on the outlook for global growth. He also warned that further animosity between Washington and Beijing may encourage Iran and China to cooperate. “If Chinese refiners start to purchase Iran oil in large volumes on a sustained basis as US tariffs rise again, WTI could drop to $40/bbl”, he said. That was not BofA’s base case, but during his chat with Bloomberg, he reiterated that it was “not crazy either”.
Fast forward a month and oil collapsed the most since 2015 after Trump threatened Beijing with 10% levies on the remainder of Chinese imports starting September 1. Crude rebounded a bit on Friday, but the message was clear: The longer the trade war drags on, the more cloudy the outlook for demand.
You might recall that just two weeks ago, the US sanctioned Chinese energy firm Zhuhai Zhengrong for dealing in Iranian oil. The same day the punitive actions were announced, Bloomberg reported that millions of barrels of Iranian oil are sitting in bonded storage at Chinese ports, just waiting to be tapped by refiners.
You’d be forgiven for thinking that Blanch’s “uber-bearish” crude scenario is now set up to play out and sure enough, in a note dated Friday, he revisits the thesis.
“Our ‘cliff scenario’ refers to the risk that China retaliates indirectly against rising US tariffs by buying Iranian oil [and] in that regard, it is worthwhile remembering that China has abided by US sanctions on Iran and taken these barrels out of their import mix”, BofA writes, referencing the green shaded area in the left pane. The breakdown of Iranian oil exports is a mirror image (right pane).
(BofA)
Now comes the bearish bit.
“The exceptionally high compliance levels by all trade partners with US sanctions on Iran have forced about 2mn b/d out of the oil market… effectively push[ing] global oil supply disruptions to the highest levels in three decades”, BofA goes on to say, adding that as a result, Iranian crude oil inventories “have quickly moved back to the top end of the range” and are “waiting for an audacious buyer”.
(BofA)
So, what happens if China decides to indirectly retaliate against US tariffs by ignoring Washington’s demands that everyone on the planet stop importing Iranian crude? That is, what happens if Beijing decides to be that “audacious buyer” Iran is waiting for?
Well, according to Blanch, oil might just collapse.
“We are not prepared to lower our oil forecasts yet, but we admit that a Chinese decision to reinitiate Iran crude purchases could send oil prices into a tailspin”, he writes, cautioning that “in the extreme, a combination of weaker demand (0.25 to 0.5mn b/d) and the return of up to 1.5mn b/d of Iran oil would weaken our projected global oil supply and demand balances between 0.5 to 2mn b/d”.
The Saudis might try to offset that by cutting production, but Blanch goes on to say that “other things being equal” the projected imbalance “could push Brent oil down by $20-30/bbl”.
In addition to prospective Saudi output cuts, Blanch does mention one other way that “other things” might not be “equal”.
“The US Navy could opt to block the movement of Iranian vessels”, he muses.
This would be taken by the market as further confirmation that no US-China trade deal is likely near term, and provoke Trump into who- knows-what, resulting in more pressure on both US and Chinese stock markets. Not clear why that’s in China’s interests.
yeah, but whether trump admits it or not, there’s only so much he can do. he can go to 25% tariffs on the entirety of Chinese imports, but after that, it would be mathematically impossible to avoid a pretty steep rise in consumer prices and even if import substitution is possible, he’s taking aim at some of those countries too (e.g., Vietnam). we’ve really yet to see a situation where another country (or another politician for that matter) just tells him to straight up pound sand. It’s entirely possible that he would fold if China just decided to say “well, we’re not trading with you at all anymore and we’ll buy as much Iranian oil as we want”. or “starting Monday, Apple is banned from selling products here”, etc. also important to remember that China is not like any other country on the planet. they could, in theory, devalue dramatically and just implement even stricter (i.e., totally draconian) capital controls. that would be a disaster for most emerging markets, but i’m not sure it would be for China. as far as equities go, they could just ban selling of A-shares and halt anything that’s falling like they did in 2015. sure, that would be a disaster in light of recent index inclusions/bigger weightings in global indices, etc. and it all sounds absurd, but you’ve got to think that after a while, somebody, somewhere is going to completely run out of patience with Trump, especially to the extent it becomes impossible to discern even a hint of a goal/end game/etc. he’s just poking China with a sharp stick every, single day and acting like he can bully them like they’re Mexico or something. it’s actually a miracle he’s gotten away with it this long.
brilliant comment H!
That would be cathartic to see, in many ways.
However, if China overtly takes on the aggressor role or is perceived as such, it risks rallying Americans behind Trump and/or facing the next Administration that is forced by public opinion to be even more hostile to China.
Even if aggressive action did force Trump to “back down” and thus probably lose in 2020, the chaos will preclude reaching a comprehensive agreement with this Administration and Congress. By playing a long game they can get to the next Administration anyway, without the risks described above.
My feeling is also that the Chinese are more prone to patient and calculated maneuvering than to rapidly escalating to an OK Corral style throwdown. That could be a bit of cultural stereotyping on my part.
Finally, I’m not sure Trump is capable of tolerating the loss of face that backing down would entail. He’s emotional, ego-driven, insecure, and playing with other people’s jobs and money. He might be more likely to simply push it all over the cliff. I’m sure the Chinese government have plenty of psychological analyses of Trump.
I doubt that a sizable number of Americans that are not Trump supporters are going to give a rat’s ass that China is buying Iranian crude. Really, they want nothing to do with Middle East wars, and to them dumping the Iran deal is just stupid. If oil prices collapse they won’t be crying either.
But here is the kicker, things have completely reversed in the last 20 years, now higher oil prices benefit the US in many ways, especially manufacturing to support shale extraction. Look what happened in 2015-16. If prices collapse I don’t even think the zombies will be able to keep up the hamster wheel of drilling and the already cloudy PMIs will get quite dark.