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Is the oil rally for real?

Oil prices have rallied off of their August lows, popping above $50 a barrel on Thursday. Is this merely another blip on a harrowing roller coaster of oil prices moves, or does it signal some return to sanity and normalcy?

Trading news certainly influenced Thursday's move: The Federal Reserve released the minutes of the September Open Market Committee session, and these conveyed continued worries about global growth and reservations about near term interest-rate increases. The markets cheered the news, and both equities and oil prices rallied.

Oil rigs L.A.
Bob Berg | Getty Images

But that's not all. The Shanghai Composite Index jumped by 3 percent Thursday, easing fears of a downturn there. For oil, this is of central importance. China has been full of contradictions in recent times. Despite apparent slower GDP growth — by some measures as low as 3.5 percent in July — oil demand has proved astoundingly robust.

According to China Oil, Gas & Petrochemicals, China's gasoline and jet-fuel demand were both up more than 20 percent in July from a year earlier, and crude demand was up more than 6 percent. At the same time, the China Association of Automobile Manufacturers reports auto sales for August fell by 3.4 percent year on year. What's the right interpretation? Are we to conclude that China has a hot economy, or is it sliding into some kind of recession?

This summer's sell-off of Chinese equities alarmed global investors about the country's economic prospects. By contrast, emerging stability in Chinese stock indices and yesterday's rally argue that China's economy may not be as weak as feared.

We have tended toward the latter view and argued China's economic weakness most likely results from an over-valued yuan. Over the last few years, the U.S. oil trade deficit has shrunk markedly as a result of both surging shale oil production, and from mid-2014, a collapse in oil prices.

This has dramatically improved U.S. terms and trade and led to a re-valuation of the dollar against the currencies of its trading partners, that is, all but China. With the exception of a small adjustment last month, Chinese monetary authorities have declined to devalue the yuan in line with the yen, won or euro. As a result, China's export sector has found itself at a competitive disadvantage and suffered accordingly. By this line of thinking, we would expect to see China's consumer sector strong and its manufacturing and export sectors weak. The data largely, but not completely, support this narrative.

On the other hand, if we attribute the U.S. currency run-up to surging shale production, then the dollar has probably peaked. U.S. oil production is dropping. Meanwhile, U.S. oil consumption growth continues to be strong. As a result, U.S. oil imports were up over the last three months. With this, the U.S. oil trade deficit will once again begin to increase in both volume and unit price terms. If we believe shale is behind dollar appreciation, then a reduction in shale production and an increase in oil prices will devalue the U.S. dollar.

The primary beneficiary of such a devaluation is China, precisely because it has, barring a minor markdown, steadfastly pegged the yuan to the dollar. Therefore, if China's problem is principally linked to an over-valued currency, rebalancing oil markets will come to the rescue, and confidence in China's outlook may well return. Jitters over China's economy may prove transient.

For oil markets, China's path is critical. If China were to enter a downturn along the lines of the Asian financial crisis of 1998, the swing in net oil demand in 2016 could be 1 million barrels per day, and perhaps even more. The rebalancing of oil markets, now well underway, could be delayed by 6 to 18 months, depending on the scenario. For U.S. independents, the effects could be brutal.



But, if the panic over China eases and the country rights itself, then oil demand growth could continue to be robust there in 2016, and other emerging markets could enjoy a tailwind as well. We expect continued downward supply revisions, and therefore balances may prove more favorable to price increases than currently envisioned.

So, it all comes down to China. If China holds together, oil-demand growth should remain strong and supply reductions, now largely baked in, will continue apace. In that world, oil prices will recover, in part due to recovering fundamentals, and also due to a weakening dollar. For long suffering oil investors, the worst may well be behind us.


Commentary by Steven Kopits, managing director, Princeton Energy Advisors.