Hard Landing In China Could Take Oil Down To $70 Per Barrel

China is increasingly giving signs that a hard landing could be in the cards, as the government cracks down on financial excesses and overheating markets amid a global slowdown.  If the world’s second largest economy were to slow down dramatically, it would have a substantial effect on commodity prices, given China’s outsized influence in those markets.  Under an extreme scenario, oil prices could drop to around $70 per barrel while copper prices would collapse 60%.  On the flip side, gold would potentially benefit from a steep sell-off in renminbi-denominated assets, according to Barclays BCS +0.28%’ economics research team.

After several months flying below the radar, China erupted into the scene over the past several weeks as a dangerous liquidity squeeze seemed to threaten the integrity of its financial system.  Amid low inflation, Chinese economic data gave further troubling signals on Wednesday, as exports contracted 3.1% in June, marking their first drop in 17 months.  While imports fell 0.7%, commodity imports took a steeper tumble, contracting 5.2%.

It comes as no surprise that China’s economic growth has been stalling.  After expanding 9.3% in 2011, GDP expansion slowed to 7.8% according to IMF data, which downgraded their growth forecasts even further for this year and next (to 7.8% and 7.7% respectively).  Things could be way worse, as “the IMF is very good at producing beautiful reports that point out the barn door is wide open, long after the animals have already run away,” as Tom Essaye of daily newsletter The Sevens Report puts it.  Nomura’s economic research team suggests there’s 30% probability that GDP drops below 7% in the second half of the year.  Barclays posits an even more extreme scenario.

If China were to truly suffer a hard landing GDP would have to fall to about 3%, Barclays’ global economics research team indicates.  And this would have an important effect on global commodity markets.  Their models show that elasticities put the fall in oil demand at 2.5% per year, which added to the de-stockpiling that would ensue, would take demand for crude down some 7% to 8%.  China accounts for about 11% of global oil demand, so that means a reduction of about 500,000 barrels of oil a day in imports.

Crude has broken to the upside as of late, after remaining relatively range-bound for several months this year.  A coup in Egypt that deposed President Mohamed Morsi, coupled with involuntary production cuts due to low prices and tight supplies, have helped pushed crude prices higher, with WTI breaking the $100 per barrel mark and Brent hitting its highest levels since April.  And while fundamentals seem to point to even higher prices, a steep decline in Chinese demand could knock international prices (i.e. Brent) all the way down to about $70 per barrel, hurting major producers like Exxon Mobil XOM -0.56% and Chevron CVX -0.3%.

The drop would be more contained than during the 2008 crisis, Barclays’ team argues, as OPEC would deliver a swift response, which coupled with the marginal cost of production could keep prices from reaching levels as low as $36 per barrel, like they did last time around.  Indeed, the beginnings of a recovery in China could help prices climb back to the $90 range quickly, they indicate, giving Big Oil some breathing room.

Another metal that is highly reactive to China is gold.  China, and India, are the largest consumers of gold in the world, accounting for more than 60% of total jewelry demand and 55% of bar and coin demand in the first quarter, according to the World Gold Council.

Gold prices have taken a beating this year, bringing with them major miners like GoldCorp and Barrick Gold ABX +0.65%.  Talk of the Fed taper and a move into risk assets, among other things, have pushed down bullion prices.  Counter intuitively, a hard landing in China could feed demand for the yellow metal, as it could shake faith in the government’s management of the economy and lead to a sell-off in renminbi-denominated assets, Barclays argues.  It could also begin to cause a change in structural demand in China, as buyers move away from purchases around festivals, high inflation, and drops in international prices, and increasingly see the yellow metal as a financial asset and a portfolio diversifier.

Base metals would take a big hit if GDP growth in China falls to 3%.  Copper would hurt the most, as it’s one of the few that still trades at a nice premium to production cost and is highly leveraged to China.  Barclays suggests it could drop 60% to around $2,535 a ton.  From Barclays: “lead [would drop] to $850/t and zinc to just over a $1000/t (for both metals, a 40-50% fall). In contrast, the potential downside for aluminum is a lot less, of 30%, to a potential $1234/t.”  On the latter point, in their latest earnings release, Alcoa AA +0.13%’s management team reiterated their expectations of 7% growth in aluminum demand and remain bullish on China.

Forbes