LONDON (Reuters) - China’s outbreak of novel coronavirus has sent oil prices sharply lower as traders reassess whether the country will be able to generate the strong economic growth needed to rebalance the market in 2020.
China and its neighbour India accounted for more than half of all incremental oil consumption between 2013 and 2018 so the economic growth of these two giant Asian economies is critical to the oil market.
Both suffered a sharp economic slowdown in late 2018 and through 2019 as a result of slumping auto sales, tightening credit conditions and, in China’s case, trade conflict with the United States.
The consequent slowdown in worldwide oil demand, coupled with continued strong increases in U.S. shale supply, sent prices tumbling during the second and third quarters of 2019 (tmsnrt.rs/2TVdAs2).
Global oil consumption is estimated to have risen by 1 million barrels per day or less last year, equivalent to a growth rate of 1.0% or less, compared with an average increase of more than 1.4% over the last 20 years.
At the same time, U.S. shale producers increased their output by 1 million barrels per day, capturing all the incremental consumption growth, squeezing rival suppliers, and forcing Saudi Arabia to cut its own output.
By the end of the year, however, traders had become increasingly optimistic consumption growth would accelerate, while shale production growth would slow further, pushing prices higher in 2020.
Hedge funds and other portfolio managers purchased oil-related futures and options equivalent to more than 530 million barrels over the 13 weeks between mid-October and early January, one of the fastest increases on record.
The giant bet on rising oil prices was essentially a gamble that growth in China and India would pick up following the Phase 1 trade deal and fiscal and monetary stimulus measures enacted by both governments.
PRICED FOR PERFECTION
The coronavirus outbreak detected in the city of Wuhan, and the quarantine measures introduced to contain it, have forced traders to reassess the likely timing and speed of any economic recovery in China.
China’s central and provincial governments have introduced restrictions on public events, tourist attractions and transport in an effort to increase “social distance” and reduce person-to-person transmission of the virus.
Many businesses and individuals will also change their behaviour voluntarily to reduce contact with potential virus carriers, cutting the demand for products and services, such as conferences, cinemas and travel.
If quarantine and social-distancing measures become sufficiently widespread and are maintained for any length of time, they are likely to have an impact on growth in first quarter and possibly later in the year.
Experience with previous outbreaks such as SARS in 2003 and MERS from 2012 suggests the economic impact of an epidemic is relatively small (a few tenths of a percentage point of GDP) and transient (six months or less).
The economic fallout is mostly indirect and stems from the impact of social distancing on consumer and business spending rather than the consequences of the illness itself.
Even if efforts to contain the outbreak to Wuhan and surrounding Hubei province fail and the epidemic spreads nationwide or globally, the economic impact is likely to be moderate.
My colleague Ritvik Carvalho has compiled an excellent survey of estimates on the impact of SARS/MERS and future pandemics (“Factbox: how a virus impacts the economy and markets”, Reuters, Jan. 21).
The problem is that the severity and duration of epidemics is extremely variable and hard to predict, depending on the base transmission rate, the effectiveness of control measures, the case fatality rate and public response.
The impact on oil prices has been magnified, moreover, because the market was previously priced for perfection –accelerating consumption and decelerating production.
Hedge fund positioning in oil had become very lopsided, with bullish positions outnumbering bearish ones by 7:1 earlier this month, leaving the market vulnerable to any disappointing news about consumption.
Over the last five years, lopsided hedge fund positioning has usually preceded a sharp reversal in the previous price trend, so the sudden fall in prices is not a surprise.
If the coronavirus outbreak extends the economic slowdown in China and the rest of Asia for a few extra months, oil prices will need to remain lower for longer to induce a further corresponding slowdown in U.S. shale output and an extension of production cuts by oil-exporting countries in the OPEC+ group.
Editing by David Evans
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