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

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.


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.






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.


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.
