A game of chicken

Published at 15:28 10 May 2019 by . Last edited 11:18 22 Aug 2019.

While most countries would be loath to get involved in two simultaneous conflicts, the Trump administration has had no qualms over opening multiple fronts at the same time. But with geopolitical tensions running high, it seems that the war that the market will have to come to terms with is not exactly the one it was expecting. At the same time as implying possible military intervention in Venezuela, and mobilising/redeploying military assets across the Middle East to confront “credible threats” that Iran will begin targeting US assets in the region, the Trump administration has decided that now is the perfect moment to call China’s ‘bluff’ on trade, setting a path for a trade war between the US and China.

After months of proclaiming how oh so close the US and China were to achieving a historic trade deal that would “level the playing field”, the US this week increased tariffs on some $200 billion worth of Chinese goods to 25%. China, of course, is expected to reciprocate, and the spectre of a protracted trade war is now back in focus for markets. With each side believing it is in a better economic position to deal with tariffs, it would appear they are about to engage in a high stakes game of chicken.

Markets have of course responded accordingly, with most risk assets pivoting to a defensive posture over the course of the week. If there is any surprise, it is that markets have not fallen more than they have. After all, risk assets were conditioned to believe that the US and China would this week deliver a trade deal that would lift tariffs, open the Chinese market to American companies, and simultaneously strengthen China’s intellectual property protections. Instead, the market is getting a return to the uncertainty of early 2018.

Perhaps markets were also not expecting to see the Trump administration take such a hard line and hence are yet to digest this development. It’s possible the Chinese also had a false sense that Trump cannot afford market weakness ahead of the elections. There has even been speculation that Trump is actually trying to optimally time the conclusion of a trade deal with the Chinese to gain maximum political momentum heading into the 2020 elections and that there isn’t any ‘real’ downside risk.

But this overly simplistic analysis ignores the very real disagreements that separate the US and China. The main sticking point revolves around technology transfer and where cloud data will reside. The US was also apparently insisting that every single Chinese commitment has to be included in the final document, but the Chinese wanted some commitments to remain confidential (but they did promise to double pinky swear to carry them out). What this process has shown is that there are very clear red lines for both sides that were never addressed at the outset.

The re-imposition of the tariffs does not mean that the US and China have hit a dead end. Far from it. We expect that the conversations will extend well into the summer. If the US has to take a little pain in the short term but ultimately secures a good trade deal that in the eyes of Trump and his main constituents “levels the playing field”, then it’s a price worth paying. But it’s also increasingly clear that the tariffs will be destructive unless they lead to a deal that causes China to cease its “predatory behaviour”. At a minimum they both need to edge a little closer to the brink in order to bring them back to the table. While both Trump and Xi clearly want a deal, neither wants or can accept a deal at any cost.

For Trump, whose current foreign policy is a shambles (Venezuela, Iran and North Korea have all not gone as planned), a victory on the China trade front would double up as a foreign policy and economic victory heading into the 2020 elections. But Xi also needs a win as the tariffs have taken a toll on the Chinese economy, and the country is still struggling with a domestic debt overhang among other challenges. Certainly, China will also suffer more from tariff increases, as some companies have already shifted operations away from China to neighbouring countries and China has a growing population that needs jobs. For this reason, we still expect the dialogue to continue even if tariffs are on the rise.

The biggest problem of all, of course, is that Xi is being asked to concede more than Trump to make this deal acceptable to the Americans and that may be politically impossible for Xi. He needs to be able to spin this as a victory back home, and the current deal structure gave him very little to crow about. China’s primary demand has been that the US must lift all tariffs as part of any comprehensive agreement, which seem reasonable if the Chinese follow through on the commitments they had made. But the Trump administration was planning to keep at least parts of the 10% in tariffs on some of the goods imported from China.

Perhaps the Chinese were hoping to simply wait out the Trump administration, after all, with elections coming in 18 months’ time, there is a chance that Trump will not be around in 2021. But China seems to be one of the few topics that commands bipartisan support in Washington as there is very little pushback from Congress on Trump’s hard-line position vis-à-vis China, with even Senate Minority Leader Chuck Schumer endorsing the president’s position.

The impact of the US tariff increases to 25% could take a little while to become fully evident given that these goods had already been subject to a 10% tariff since September and the higher rate will only apply to goods departing China from today. There is no doubt that both countries will suffer from an all-out trade war. The only question that remains in this game of chicken is who blinks first?

Mind the gap
For the oil market, the massive gap between the physical and financial market right now is unbearable for traders. Each day crude timespreads keep going vertical while the flat price seems to be in a down elevator. So, either the market is wrong, or the market is wrong. We have 100% confidence that it is one of those two possibilities. But for those that have been praying for a dip in prices, this may be it.

The problem now is that there are two competing narratives for traders to digest. On the one hand, there is the spectre of an escalating trade war between the US and China and all the demand uncertainty that goes with it. On the other hand, the physical oil market is laser focused on the continued tightening in supply due to the sanctions on Venezuela and Iran, and a Saudi Arabia that on balance still wants to see a tighter oil market and has a predilection for higher rather than lower prices. With the Saudis in no rush to fill future supply gaps in the way it did a year ago, and the US squeezing Iran and Venezuela, oil market fundamentals continue to tighten. This is most clearly evidenced by crude timespreads and differentials which are roofing pretty much across the globe.

Notably, Brent this week has been bouncing off its 50-day moving average and has now settled back into the up-channel from the start of the year. Considering the negative risk sentiment from the collapse of the US-China trade talks, this is a constructive signal. Right now, Brent timespreads are implying an oil price $15–20 per barrel higher. And yet, despite that, the Trump administration keeps stoking the geopolitical fires and is playing with matches in the Middle East.

Fig 1: Brent vs 50 day moving average, $/b Fig 2: Brent Jul-Aug spread, $/b
Source: Bloomberg, Energy Aspects Source: Bloomberg, Energy Aspects

Stay in your lane, bro!
Late Thursday, Secretary of State Mike Pompeo issued a bellicose warning to Iran to effectively 'stay in its lane'. He noted that “the regime in Tehran should understand that any attacks by them or their proxies of any identity against US interests or citizens will be answered with a swift and decisive US response. Our restraint to this point should not be mistaken by Iran for a lack of resolve.” This is as close to an official double dog dare as you are going to get, coming hot on the heels of the abrupt announcements of military redeployments across the Middle East under the pretext of “new” intelligence warning of imminent attacks by the Iranians against US and allied targets across the region. Some of the recent justifications for these redeployments echo the type of cherry picking of intelligence from the pre-Iraq War days under the direction of the original Neo-cons Paul Wolfowitz and Doug Feith. In essence, Bolton and Pompeo are looking for intel to match their Iran narrative rather than letting the intel dictate the narrative.

In truth, not since ‘Love shack’ was released in 1989 have we seen this much coverage of the movements and tours of the B-52s. But the US comments towards Iran of late have been so filled with hyperbole that we don’t know if they are getting their inspiration from Game of Thrones or House of Cards. There is so much bluster in the US rhetoric that it’s hard to take it seriously if the stakes weren’t so high. The situation in the Middle East at the moment is fraught with danger. The US is clearly trying to goad the Iranian regime into doing something rash that would then require a US/Israeli response. This means markets must remain vigilant. The risks of overreach are very high.

The Outlook
Brent: The crude market continues to tighten, as traders scramble for crude following the loss of Venezuelan and Iranian production and as refiners begin to come out of hibernation. Many balances, including ours, assume that there will be some baseline of Iranian exports that will be able to get around the US sanctions, roughly 0.6 mb/d or so. We understand that both India and China have loaded very little from Iran so far in May. Those numbers may go back up in June/July, but the May numbers suggest that Iranian exports should come in lower than what most are expecting, as the market adjusts to the new sanctions reality as dictated by the Trump administration a couple of weeks ago. Part of the problem is that even though cargoes will continue to load, some of that crude will not be available to the market. For example, nearly half of the Iranian loadings in the second half of April are likely destined for floating storage due to the shortage of buyers.

Meanwhile, though Saudi Arabia is offering more oil to some of its customers, our understanding is that only India has received some optionality for more volumes, totalling 0.2 mb/d. It is unclear whether this will be incrementally higher exports or simply even more shifting of existing export flows from west to east. Its also unclear that those asking for more crude will get the quality of crude that they are asking for. We note that deliveries into the US have fallen again and the Saudis appear in no rush to increase volumes there. With US refiners coming out of maintenance, competition for crude will only intensify in the coming weeks and months. With the May JMMC meeting just over a week away, the Kingdom is not positioning like it is about to flood the market with crude.

Fig 3: Oman differential to Dubai, $/b Fig 4: Saudi Arab Medium OSP to Asia, $/b
Source: Argus Media Group, Energy Aspects Source: MEES, Argus Media Group, Energy Aspects

WTI: There is no denying that this year has seen an exceptionally large amount of refinery outages. Historically, runs ramp by over 1 mb/d between March and May, and thus far this year runs have only reason by around one-third of that amount and remain some 0.8 mb/d below their seasonal average. As runs move higher from here, the pull on crude stocks should begin to be felt and total US stocks should draw. But we expect Cushing stocks to rise over May, and this week’s 0.82 mb build was above our expectations and was driven by pipeline and refinery outages (see Data review: Department of Energy, 8 May 2018)

Total US crude balances remain constructive, with crude stocks drawing by 4 mb last week to 467 mb, compared to the five-year average draw of 1.2 mb. We anticipate year-end stock levels of 430 mb. However, the sizable adjustment factors seen in recent prints remain a large concern for balances. As we mention in our analysis of the Petroleum Supply Monthly (PSM) last week (see Data Review: US oil and shale output, 30 April 2019 ), we expect US production to grow by 1.3 mb/d y/y in 2019, with 0.79 mb/d of that growth found in the Permian. Many estimates are calling for much higher figures, based on the unaccounted-for EIA supply adjustment factor. While we believe US production is growing, we do not believe its surging and indeed, this week, the adjustment factor swung by 1.5 mb/d to -0.86 mb/d.

Fig 5: US refinery runs ytd change, m b/d Fig 6: Saudi exports to US 4 week avg, mb/d
Source: EIA, Energy Aspects Source: EIA, Energy Aspects

Currently, crude imports into the US remain low, led be declines from Saudi and Venezuela. Meanwhile, US crude oil exports have risen from 1.6 mb/d in February 2018 to 3.0 mb/d in February. However, the weekly data suggest that April has averaged 2.5 mb/d, with the most recent reading of 2.3 mb/d, well off those February highs. Thus, if imports remain weak, which they should, rising domestic crude demand will either cause inventories to draw or exports to fall further. As the saying goes…something’s gotta give.

Yasser Elguindi, Energy Market Strategist
+1 646 760 8100 (direct)

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