Geopolitical Monitor | Tanmay Kadam: The escalating trade war between U.S. and China has given rise to the prospect of two possible game-changing events for oil markets: First, more of Iran’s crude oil finding its way into the market; and second, the disruption of global oil markets due to oversupply issues caused by this Iranian oil.

On August 1, President Trump announced that his administration would impose additional 10% tariffs on $300 billion worth of Chinese imports starting from September 1. In response, China depreciated its currency sharply to its lowest level against the US dollar in more than a decade, and announced that its companies have stopped purchasing American agricultural products. Mr. Trump escalated further by having China designated a currency manipulator by the Treasury Department. This upward ratcheting of tensions between the two countries caused Brent prices to plunge 7.6% after President Trump’s initial announcement of the 10% tariff on Chinese goods, and then again drop down more than 3% on August 5 following the depreciation of the yuan. Prices recovered the next day, as traders betting on falling prices bought back contracts to lock in profits. International Benchmark Brent Crude futures had climbed 58 cents or 1% to $60.39 a barrel by 0635 GMT on Tuesday from its lowest mark of $59.07, recorded on January 14.

The plunge in oil prices is a result of concerns over slowing economic growth and lower oil demand expectations because of that. Investor sentiment and business confidence is greatly affected by the ongoing trade war between the U.S. and China, which happen to be the two largest economic powers in the world. There is an atmosphere of uncertainty surrounding oil demand, stemming from fears of a decline in economic activity at the global level and a belief that if this trade war continues to escalate, the world be plunged into recession. Research firm TS Lombard warned in June that an unresolved Sino-American trade war “has the potential to trigger a recession in 2020, if not before.” Moreover, Goldman Sachs very recently announced that it does not expect the U.S. and China to agree on a deal to end their trade dispute before the November 2020 presidential elections.

Analysts have revised their oil demand growth forecasts downward according to a report in Reuters in June. FACTS Global Energy Group, an energy consultancy, reduced its global oil demand growth forecast to 1 million bpd. Barclays bank said in June that it had scaled back its economic growth outlooks for the United States, China, India, and Brazil, countries that represent more than three quarters of global oil demand. The British bank also cut its oil demand growth forecast by 300,000 bpd to 1 million bpd. And, although Bank of America Merrill Lynch estimates growth to be around 1.2 million bpd for 2019, it said that global oil demand growth is running at its weakest rate since 2012.

These are just the demand side risks that oil markets are facing, but it is possible that in the near future the market will face disruptive supply side risks as well. Iranian crude, which is facing dwindling demand in the market due to the US sanctions, has a potential to pose such risks.

As per recent reports, Iranian oil tankers have been quietly offloading their supply into Chinese ports. The estimates of the volume of Iranian crude that has been shipped to China between January and May vary from 12 million to 14 million barrels. John Kilduff, founding partner of energy trading firm Again Capital estimates that another 20 million barrels are likely en route to China. Moreover, a report in the Financial Times, published last Moday, said that Bank of Kunlun, a subsidiary of China National Petroleum Corporation, in recent months has employed a fleet of tankers in an apparent bid to move oil from Iran to China. At least three Kunlun-linked tankers have been spotted interacting with Iranian vessels since May in Planet Labs imagery, which Financial Times obtained from TankerTrackers, a group that monitors oil shipments. If this is true, then perhaps even China is actively helping Iran in shipping its oil to its ports.

China is keeping this oil in what is known as ‘bonded storage,’ which means that the oil has not been cleared through Chinese customs and is not being used, therefore not actually violating US sanctions. Iran’s reduced exports have increased its onshore and floating storage, but it cannot halt pumping oil because of this, as leaving oil underground could lead to permanent damage to its oil wells. Therefore, bonded storage for its oil is an excellent solution for Iran to continue pumping oil and avoid having to use so many of its tankers as floating storage facilities.

This arrangement gives Iran and China options in the case that China decides to defy US sanctions, which it probably will if its trade dispute with Washington deteriorates. For its part, Iran would most certainly welcome any opportunity to sell its oil. This oil obviously has to be discounted hugely due to the risks attached to it, and China would benefit from these major discounts. Thus, it represents a good deal for both countries. A report on CNBC Markets highlighted this possibility before the depreciation of yuan and halting of Chinese purchases of US agricultural goods. It said that as the markets waited for a Chinese response to the latest tariff threat, analysts warned that, “oil volatility is set to rise again,” because purchases of Iranian oil were being weighed as one of China’s possible responses.

Even if Beijing responded differently this time, it is possible that China might decide to purchase Iranian oil in future. If this happens, crude oil prices could sink by as much as $30 a barrel according to Bank of America Merrill Lynch, as reported in CNBC Markets. “While we retain our $60 a barrel Brent forecast for next year, we admit that a Chinese decision to reinitiate Iran crude purchases could send oil prices into a tailspin,” a BofA Merrill Lynch Global Research report said Friday, warning that prices could sink by as much as $20-30 a barrel in that scenario.

There obviously are some significant odds behind this prospect, as a decision to defy US sanctions would hurt the Chinese economy even more. China’s state-owned refineries would also lose access to the US financial system for their refined products. So it remains to be seen what developments lie ahead in this trade war, how trade negotiations between the two countries unfold, and accordingly what China decides to do with the Iranian oil sitting in its ports. Together, these variables could decide the short-term fate of global oil markets.