Can the US-China Trade War Spiral into a Crude Oil War?

This August is turning out to be an eventful month. On August 1, President Trump announced tariffs on the remaining Chinese goods entering the US, a day after the Fed cut interest rates for the first time since 2008. China escalated the trade war shortly after that by devaluing the yuan to support Chinese exporters.

In addition to the trade environment being under pressure, the markets also seem to be cooling off. The S&P 500 (SPY), which hit an all-time high not too long ago, has lost 3.23% so far in August. Plus, the tech-heavy Nasdaq (QQQ) has seen a 3.82% fall in the first five trading sessions of August.

JPMorgan Chase has already warned of a stock market crash this quarter. The Treasury (TLT) yield curve inversion has worsened, with 10-year yields dropping below 1.6%.

From a trade war to a crude oil war?

In the commodity markets, we have seen a flight to safety with gold (GLD) up almost 5% so far in August. However, a more significant movement has happened in oil markets (USO). WTI crude futures have lost 10.5% so far this month due to the yuan’s devaluation and the EIA’s lower demand forecast. Both sides in the trade war have plenty of ammo to keep playing the game. However, crude oil might be the most influential element.

This week, CNBC cited Bank of America Merrill Lynch research that crude oil prices could fall substantially if China defies US sanctions to restore the Iranian crude oil supply. China has already vowed to apply countermeasures to US tariffs—this could well be one of them.

As the world’s largest importer of crude oil, China accounted for 20.2% of the world’s crude imports in 2018, giving the country substantial negotiating power in the oil markets. India and China have already set up a bloc to get better terms from oil-exporting countries and OPEC. China’s defiance could also lead to other Asian countries, including India, piggybacking to import cheap Iranian oil.

Beyond the trade war, Uncle Sam walks alone

In 2015, Iran, the US, and other world powers reached an agreement to stop Iran from making nuclear weapons. However, last year, President Trump unilaterally withdrew from the deal, inviting pushback from other allies. The US reinstated its sanctions on Iran in November 2018.

In April, the Trump administration announced the end of waivers for eight countries (including India and China) importing Iranian crude. The trade war escalated in May as Trump announced further tariffs on Chinese imports.

Although the US is out of the deal, Iran is pushing European powers as well as China to protect itself from American sanctions. With the US standing alone on Iran front, China may seize the opportunity to use the Iran issue as a negotiating tactic in the ongoing trade war. This move is expected to reduce China’s energy bill, as well as much of the rest of the world.

Why would it matter?

Iran is not one of the top exporters of crude oil. However, Iran oil exports had slumped to just 550,000 barrels a day in June from 2.5 million barrels a day in June 2018. If the 2 million barrels of crude oil comes back in the market, it might change the overall demand-supply dynamics. Plus, an extended trade war could lead to a fall in global oil demand. China’s crude oil imports stood at 9.7 million barrels a day in June.

Although the US doesn’t export much crude oil to China, the additional supply of cheap Iranian oil could pressure both Brent and WTI crude prices. As a result, the American energy sector could experience a more significant loss, as the marginal cost of production in the US is higher than in the Middle East.

Analysts are already bearing on the US energy sector. Analysts expect Chevron’s (CVX) EPS to fall 8.5% during this quarter and 3.1% in the next. Chevron’s revenue growth is also expected to fall this quarter and in the next. ExxonMobil’s (XOM) revenues are expected to fall 7.5%, and its EPS could decline almost 30% this quarter. If oil prices slump further, it could exacerbate the matter for oil companies.

Apart from oil companies, industrial companies that provide services for oil extraction are also impacted by low oil prices. Caterpillar (CAT), Halliburton (HAL), and Schlumberger (SLB) provide oilfield services. Caterpillar has dropped 8.27% so far in August while HAL and SLB have fallen 14.57% and 13.1%, respectively, through August 7.

Crude oil and the auto industry

A slump in crude oil may create fresh troubles for electric car manufacturers like Tesla and Nio. Tesla has already lost around 30% this year. When oil prices slumped in 2014, Tesla saw a similar decline. NIO has lost over half its value so far in 2019.

Cheap oil could revive the fortunes of legacy automakers like Ford and General Motors, as consumers may stick to fossil-powered vehicles if gas is cheap. GM and Ford have lost market share to Tesla so far this year. Both GM and Ford have seen falling unit sales so far this year.

Uber and Lyft may be at a disadvantage from falling oil prices, as consumers could return to driving instead of using a ride-hailing service. Lyft released its earnings yesterday, outperforming expectations. Uber is scheduled to report its earnings today. Both companies are far from being profitable.

Apart from the crude oil imports, China holds additional cards in the trade war against the US. China holds over $3 trillion in foreign exchange and $1.1 trillion in US Treasuries.