Authored by Tom Holland of Gavekal
Global risk assets got a boost last week from news that the US and China will resume their stalled trade talks in October. The assets that benefited included oil, which rallied 6% on expectations that increased chances of a US-China trade deal will be positive for global growth, and therefore for energy prices. It is likely the oil price will now find further short term support from news at the weekend that Saudi Arabia has replaced its oil minister with a half-brother of the kingdom’s effective ruler, crown prince Mohammad bin Salman, who favors higher prices.
Given the close correlation between the oil price and inflation expectations, these developments might seem to point to higher than expected future inflation, and a reduced chance of central bank easing, which would be bearish for overpriced global bond markets.
However, other news last week can be considered bearish for both the oil price and global growth expectations. In particular, reports that China has signed a long term agreement to buy large quantities of Iranian oil in defiance of US sanctions will weigh on global crude prices and further complicate US-China talks, reducing the chances of a deal before the 2020 US election. In effect, the world is now facing a four-way tug of war over the oil price. The clearest position is that of Riyadh, which wants higher oil prices. Outgoing oil minister Khalid Al-Falih was appointed in 2016 to secure Opec production cuts and juice up prices, both to plug Saudi’s fiscal deficit and to support the planned IPO of state oil giant Aramco. However, at US$62/bbl, the price of Brent remains far below Riyadh’s near term target of US$75-80/bbl, hence Al-Falih’s replacement with a royal insider.
Washington’s position is more ambivalent. Although the US administration has repeated its determination to drive Iran’s oil exports to zero, Donald Trump’s twitter feed indicates his gasoline price pain threshold kicks in when Brent exceeds US$75/bbl.
Although obfuscated by ongoing talks with European nations and repeated threats to resume nuclear research and development, Iran’s position is also relatively straightforward: it desperately needs to sell its oil. Since the US withdrew from the Iran nuclear deal in May 2018, and following the tightening of US sanctions in May this year, Opec data shows Iranian oil production has slumped from 3.8mn bpd to 2.2mn bpd in July. Assuming domestic consumption has remained constant, this implies Iran’s exports have fallen from 2.3mn bpd to roughly 700,000 bpd.
Much of this oil is being shipped to China. Customs data shows that China imported some 220,000 bpd in July. However, the actual size of shipments is likely to be greater, given that some Iranian oil will have been transshipped at sea, likely disguising its origin, while more will have been held in bonded storage, without passing through Chinese customs. Nevertheless, the point is clear: Iran needs to ship its oil regardless of US sanctions, and China is its biggest market.
Hence the significance of reports last week that Tehran has fleshed out its 2016 “comprehensive strategic partnership” with Beijing. Under a 25-year deal reportedly sealed in August, Iran will agree to sell its oil and gas to China at a guaranteed discount to prevailing market prices of at least 12%, plus an additional discount of up to 8% to reflect risk. In addition, to bypass the US dollar-denominated international financial system, China will pay for its purchases in renminbi.
In return, China will invest some US$80bn over the next five years to upgrade Iran’s energy production facilities and infrastructure (and possibly much more over the following 20 years). And to safeguard its investments, Beijing will deploy “up to 5,000 Chinese security personnel on the ground in Iran,” as well as protecting shipments of Iranian oil from the Persian Gulf to China.
The benefits of such a deal to Tehran are manifold. It gets much-needed inward investment. It secures a market for its oil and gas. It breaks its dependence on the US dollar. It gets a deterrent against possible US or Israeli military strikes against its energy industry. And it reduces its economic dependence on powers that would otherwise insist it curtail its nuclear program. In short, it gets to thumb its nose at the West, and at Washington in particular.
This leaves China’s position. Discounted energy imports are always enticing, but in this case they come at a cost. A deal to buy Iranian oil in defiance of US sanctions is only likely to antagonize Washington, further complicating already knotty trade talks and reducing any chance of a resolution to the tariff war. On the other hand, China’s leaders may well have already concluded that the probability of an advantageous deal with the US is small, and that they are better off making the best of a bad job.
If so, a long term oil purchase and investment agreement with Tehran makes sense. Not only does China get cheap oil and further its Belt and Road ambitions. By paying for oil imports in its own currency it advances a big step towards creating a new monetary bloc centered on the renminbi, an essential move if the US is to pursue economic decoupling and strategic rivalry (and one supported by Russian plans to issue renminbi bonds in the coming months).
These are long term considerations. However, the last week’s developments have important near term implications. With the appointment of a new oil minister, Saudi is signaling that it will attempt to pursue a higher oil price. However, the reported Iranian agreement with China will weigh on the international price of oil for two reasons.
- There is the prospect that Iran could quickly ramp up its oil shipments to China to as much as 2mn bpd (the volume of its global exports before sanctions kicked in). The displacement effects of selling so much oil (equivalent to 2% of global production) at a 20% discount to the market would weigh heavily on global prices.
- A deal between China and Iran in defiance of US sanctions will further complicate US-China trade talks that have already been complicated by the dispute over Huawei. As a result, the chances of a deal will recede even more into the distance. That will weigh on expectations for global growth, which will further weigh on the international price of oil.
Together, these factors are likely to outweigh Riyadh’s efforts to support the oil price, given that in a fragmented market, additional Saudi production cuts are only likely to result in a further loss of market share. As a result, inflation expectations are set to remain subdued in the near to medium term. And while the longer term effect of US-China economic decoupling on inflation is debatable, so far the market clearly believes trade war escalation and economic disengagement to be disinflationary. The conclusion is that on balance the four-way fight over the international oil market will do nothing to burst the global bond bubble, and may well keep it inflated for even longer.