The Downside Risk For Oil Prices Is Undeniable

Inverting yield curves, a shrinking German economy, Brexit, two trade wars, tariffs and slowing industrial activity in China are all pointing to the possibility of a recession. Even if we assume, as I’m sure most are hoping, that despite these signals a recession does not occur – the current market sentiment is undoubtedly a cause of concern for commodities like crude oil. Oil markets look set to be bearish or at least range bound for the rest of the year. Macroeconomic forces are coming together in such a way that a bullish case for crude oil is increasingly difficult to justify.

The truce at the recent G20 meeting in Osaka between the U.S. and China proved to be very short lived. Oil prices plunged sharply after Trump’s announcement of 10 percent tariffs on an additional $300 billion of Chinese goods. And while the recent announcement by the United States Trade Representative (USTR) to delay these tariffs until the 15th December gave markets some hope, it is unlikely to lead to a breakthrough in the trade war. Realistically, this delay was designed to provide cover for the holiday season and after that, it will be business as usual. The President himself has made it clear that, despite the talks, he is not ready for a deal. The current unrest in Hong Kong is likely to sour relations between the two countries even further. And to make matters worse for oil markets, there is another trade war brewing in the East Asia, one between Japan and South Korea.

The Japanese and South Korean trade war may be a recent phenomenon, but the tensions between these two countries goes back as far as the Second World War. During the war, Japan exploited Korean workers in the form of forced labor, leading South Korea to ask Japan for reparations for human rights abuses and the country’s wartime loss. This claim led to Japan tightening controls and implementing trade restrictions on South Korea – removing the country from its “white list”. In the meantime, South Korea began considering abolishing Japan’s preferred trade nation status and downgrading it. To add to tensions, Japan has accused South Korea of leaking tech secrets to North Korea, although there is no evidence for that accusation. The effects of this trade war, as it develops, could be profound on the global economy. Take for example Samsung and SK Hynix, which account for 60 percent of world’s DRAM chips, used in everyday electronics objects around the world. This second trade war is sure to be negative for the global economy, adding yet another bearish factor for oil markets to deal with.

Despite the many economic warning signs that are flashing, such as the U.S. treasury yield curve for 10 year bonds falling below a 2 year rate, some analysts are optimistic that we will see a repeat of 1960 – when the yield curves inverted but a recession was avoided. We could, for example, experience a scenario in which the Fed continues to cut interest rates. This would result in a depreciated dollar, making it more affordable for other countries to buy crude oil and causing the price of crude to go higher. This optimistic outlook, however, is based on one key assumption – stable demand. The assumption of stable demand is far from a reasonable one, with the IEA and EIA having continuously cut their demand estimates this year. Two trade wars and recessionary concerns would only exacerbate this downward trend, and it is likely that other central banks around the world are also gearing up to reduce interest rates, offsetting the effect of a falling dollar and keeping oil prices under pressure.

Of course, a war in the Middle East would void much of the above analysis. But we can gauge the sentiment in that regard as well. President Trump has categorically said that he is not looking for a war with Iran. This statement was reciprocated by Muhammad Zarif, Iran’s foreign minister, when he stated that “we are not seeking war”. While geopolitical tensions in the Middle East are high, there appears to be very little support for escalating those tensions into a military conflict.

Amidst all of this there are very few factors pointing to an upward rally in oil prices. Inventory withdrawals are temporarily putting a bottom under prices, but against the backdrop of record Saudi cuts and falling demand, fundamentals are unlikely to spark a bull run any time soon. China and the U.S. will only reach a deal in the trade war when both the sides agree to compromise, and there is no sign of that happening any time soon. Oil traders should be particularly careful in today’s markets, bearish sentiment has well and truly taken over markets.

By Osama Rizvi for Oilprice.com