Oil may crack further if China data confirm slowdown

Oil gas derrick
Getty Images

Benchmark oil prices may soften further this week if official data confirm factory activity in China slowed to its slowest pace in 11 months, implying lower demand for primary inputs from the world's second-largest economy.

Despite correcting lower last week, both Brent and U.S. crude futures remain over $100 a barrel and many believe current prices are too high and don't reflect weaker global fundamentals of ample supply, tepid demand and slowing emerging market growth.

"I still feel we have a $5-8 premium in the market which is too expensive," said Jonathan Barratt, chief executive of Barratt's Bulletin, a commodity-markets newsletter in Sydney, who has a 'bearish' recommendation on the oil market this week. "I'm looking for August 1 China PMI for confirmation of the slowdown," Barratt said, adding he is 'short' the market or betting prices will fall. "The market is trading with economics."

Exactly three-quarters of those polled in CNBC's weekly sentiment survey (21 out of 28) believe prices will decline, 14 percent of respondents (four out of 28) say prices will gain while three are 'neutral'.

(Read more: US oil ends near $105, gripped by fears of faltering China)

Oil markets face multiple event risks this week. Three major central banks (the Federal Reserve, the European Central Bank and the bank of England) hold policy meetings while scheduled U.S. data releases - including second-quarter GDP and July non-farm payrolls – will take on heightened prominence as investors scrutinize those numbers to determine when the Fed will scale back the pace of asset purchases.

Economists expect the U.S. economy created 185,000 jobs last month, short of the 200,000 nine-month average. Meanwhile, average forecasts suggest the economy grew at an annual rate of 1 percent in the second-quarter. However, a number of economists have cut their quarterly estimates prompted by disappointing U.S. data last week and some even warn of a negative surprise. Even so, markets may be inclined to discount the GDP number, looking ahead instead to what forward indicators suggest about the second half of the year.

"The GDP report will likely be awful this week but it's a stale number and will be more useful as a headline than as a major influence on oil prices," said Tom Essaye, President of Kinsale Trading. "If growth doesn't accelerate in the third quarter, then that will weigh on crude but for now the Q2 GDP report shouldn't cause much more than a temporary blip, if at all."

How the U.S. dollar reacts to the data will be a key determinant for commodities and oil, analysts say.

Softer data may vindicate the Fed's dovish stance and push out the timeframe to scale back asset purchases from the September consensus currently. If the Fed does reaffirm interest rates remain low, and if policymakers lower the threshold for inflation, that may weaken the U.S. dollar, proving supportive for cyclical markets like oil. A weaker dollar makes dollar-denominated commodities cheaper for importers paying in currencies such as euros.

(Read more: Scarceonomics: Why oil sheikhs are learning how to farm)

"I think that the FOMC will be slightly dovish," sending the dollar lower and benefitting oil, said Mark Waggoner, President of Excel Futures. "However, GDP and employment will come out quite positive," possibly sending bond prices lower, driving yields higher. "This should rally the dollar and pressure energy," Waggoner said.

Ultimately, price action in the oil market is most likely to be guided by the China data releases. Beijing releases its closely-watched Purchasing Managers' Index (PMI) for July this Thursday and private forecaster HSBC publishes its final PMI factory activity gauge on the same day.

Brent crude fell as low as $106.63 a barrel on Friday and recorded its second weekly decline after touching a three-and-a-half-month high. U.S. oil traded as low as $104 on Friday before rebounding to close at $104.70, the lowest in two weeks.

The catalyst for last week's decline came from China's manufacturing activity which sank to an 11-month low in July, according to preliminary data from HSBC. On the supply front, U.S. crude output last week hit its highest since 1990, while crude inventories showed a much smaller fall in the week to July 19 than earlier in the month, data from the U.S. Energy Information Administration showed.

(Read more: Earnings week ahead: Media and oil giants in focus)

IG Market's strategist Kelly Teoh expects WTI to consolidate around current levels but may revisit $104. "Medium term we are bullish with a target price of $108," Teoh said, adding that the expectation of a slowdown in China is "priced in" while Fed Chairman Ben Bernanke will stay on message with the stimulus program.

Nonetheless, the bears appear to have the upper hand this week. "We were stopped out of long positions on Tuesday, so we're happy with the trade," said Tom Weber, Senior Commodity Advisor at Portfolio Managers, Inc. Commodity Futures & Options in Los Angeles. "It seems like there is an awakening to the fact of a China slowdown. Geopolitical risk seems to have burnt itself out for the moment. I wouldn't be surprised to see oil test the $100 level."

—By CNBC's Sri Jegarajah. Follow him on Twitter @cnbcSri.