The 'black swan' that could sink oil markets

As an oil markets analyst, I monitor the range of factors determining oil supply, demand, and prices. Some of these, like rig productivity and decline rates, are micro and technical. Others, like GDP growth, are macro. Above them all, however, are "black swans," events which can make a mockery of ordinary supply and demand analysis.

A security guard gestures outside the Great Hall of the People in Beijing, China.
Johannes Eisele | AFP | Getty Images
A security guard gestures outside the Great Hall of the People in Beijing, China.

Today, the biggest black swan is China, the risk we need to understand above all else. Most investors associate China risk with its economy, the chance of a financial crisis or recession. But the bigger risk today, I would argue, is China's politics. In the last few months, the country's political climate has deteriorated at an alarming pace.

British citizens have been abducted in Hong Kong by the Chinese government and censorship of foreign media has increased. Just recently, the 50th anniversary of Mao's Cultural Revolution-a grim decade when as many as 30 million Chinese are thought to have died of political violence and starvation-was commemorated with a grand concert and celebration. Apparently, the Cultural Revolution is returning to fashion.

We still tend to think of China as that of the government of Deng Xiaoping, who placed China firmly on a liberalizing, market-oriented track. Over three decades, we have become used to China's 10 percent GDP growth rates and a series of economic achievements, of two power plants opened every week and a new airport for every city.

That China is fading. In its place has arisen a restless and unhappy country. Making a buck has been replaced with making the rest of Asia bow down to Chinese superiority. Power, not money, is the currency of the realm.

The impacts are to be seen both domestically and abroad. At home, Beijing is pressuring foreign businesses. Chinese authorities have shut down Apple's iTunes service, and Disney's joint venture with Alibaba has been pulled. NGO's are coming under direct police supervision, and many are expected to close. Christian churches are being systematically demolished.

For those of us accustomed to thinking of China as a dynamic, prosperous and constructive power, these developments are hard to digest. Back in 2013, the Rhodium Group, a consultancy with a focus on China, argued the liberal case: "The losses China would incur by reversing its hard-won market reforms far exceed any economic or political dividends from taking such a path" as excluding foreign suppliers. Most business people still feel that way, and it is certainly true.

The evidence, however, suggests that President Xi Jinping does not regard economics as a priority. Indeed, he has specifically denounced "Western capitalist values." What do these values represent if not personal freedom and economic progress? Xi has stated it explicitly: he rejects capitalism, as westerners might think of it, as his prime objective.

His real priorities are more evident in the country's foreign policy. The centerpiece of Xi's policy is the building and militarizing of artificial islands in the South China Sea, with an eye to annexing a 300,000 square mile triangle bounded by China's Hainan Island to the west, the southern tip of Vietnam and Manila in the east.

Why is China antagonizing literally all its major trading partners with this strategy? China is under no threat in the South China Sea, and the gains, beyond political control, are negligible. The venture fails any reasonable cost/benefit analysis. As a point of comparison, the U.S. Gulf of Mexico produces about $25 billion of oil and gas revenues per year, perhaps $30 billion if other economic activities are added. The South China Sea is considered less promising.

On the other hand, China exported $2.3 trillion goods and services in 2015. A loss of only 1 percent of this trade would offset the full economic benefit of the South China Sea. Why risk it?

The militarization of the South China Sea makes sense only in terms of power politics. As he does domestically, Xi wants dominance abroad, certainly in East Asia. Domination is the goal, even at the cost of economic sacrifice.

The result: The U.S. and China are increasingly facing off in the South China Sea. Last week, China scrambled fighter jets when a U.S. navy ship, in a freedom of navigation exercise, sailed close to the disputed Fiery Cross Reef. If this continues, sooner or later we will find ourselves in a shooting war.

For oil markets, Xi's policies represent risks great and small. The lesser risk is that the continued crackdown on businesses and foreigners will sap the appetite to invest in and trade with China. At best, the outcome would be sanctions, and at worst, well, something a lot worse. Continued internal and external tensions in China will produce exactly the pattern we have seen, a progressive slowing of the Chinese economy.

There will be no stabilization of GDP growth above 6 percent, but rather a continued unwinding. The Cultural Revolution was no boom time; rather it stands as a Chinese holocaust of poverty, oppression and death. If Xi wants to be the new Mao, then China's economy will perform as it did under Mao.

What are the implications for oil markets? First, oil demand is a function of GDP. If China's GDP continues to unravel, as it will in the political climate Xi is creating, then China's oil consumption will disappoint, and oil markets will take longer to clear than currently expected.

We anticipate markets will clear during the summer. On the other hand, a weakening China could put this off by perhaps two quarters. And as importantly, talk of yuan devaluation, which would be implied by unraveling growth, has tended to knock several dollars off the oil price. Should the Chinese economy continue to unwind without outright hostilities, we would expect oil prices to decline less than $12 per barrel from current levels, but meaningful price recovery to be delayed into 2017.

The far greater risk is a shooting war or China's annexation of the South China Sea. This could lead to oil embargoes, and much, much worse.The only certainty in such an event is that out-of-the-money options will prove a good bet. For now, let's hope for the best and trust cooler heads will prevail.

Nevertheless, we cannot be complacent. The risk is real. China's politics has become the black swan we cannot afford to ignore.

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

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