The U.S. and China appear to be making progress on trade talks ahead of the G20 meeting, but should they fail, the fallout for the oil market could be significant.

If the U.S. and China cannot come to an agreement and the trade fight escalates, oil prices could plunge to $30 per barrel, according to Bank of America Merrill Lynch.

That is because the Trump administration has threatened to impose tariffs on $300 billion worth of Chinese imports, which would cover just about every Chinese good coming into the country. The economic pain on the global economy would be substantial, but the impact would be especially damaging on China. In response, Beijing might feel compelled to let the yuan weaken in an effort to prevent a collapse of exports.

That, in turn, would severely cut down on oil demand. Since crude is priced in dollars, a weaker yuan would make oil vastly more expensive in China.

Moreover, if the fragile U.S.-China trade talks fall apart, China would have little incentive to follow American directives. As a result, it may scoff at demands to cease purchasing oil from Iran. The combined effects of a weaker global economy, dwindling Chinese demand following a weakening of the currency, and Chinese imports keeping Iranian oil exports online would lead to a cratering of oil prices to $30 per barrel, Bank of America’s global head of commodities Francisco Blanch said in a Bloomberg interview.

The comments echo conclusions the investment bank made in a mid-June report, although its worst-case scenario for oil prices seems to have grown more pessimistic. “A further escalation in US tariffs on Chinese goods could jointly drive global economic growth a lot lower and encourage Iran-China co-operation,” Bank of America analysts wrote. “If Chinese refiners start to purchase Iran oil in large volumes on a sustained basis as US tariffs rise again, WTI could drop to $40/bbl.” That’s what the bank said in mid-June. Now, it says the downside could be as low as $30 per barrel. Related: Oil Industry Boosts Spending… But There’s A Catch

To be sure, Bank of America does not say the scenario is necessarily likely, but it is a potential worst-case outcome for oil.

Much hinges on what happens on the sidelines of the G-20 summit. “Our global demand growth projections of 0.93mn b/d and 1.00 mn b/d for 2019 and 2020 are roughly aligned with our economists' GDP forecasts,” Bank of America analysts wrote. “Yet there is a risk we end up being too optimistic if the US-China trade relationship deteriorates further.”

For now, oil prices have rebounded on U.S.-Iran tension. The war of words between Trump and top Iranian officials is a reminder that the prospect of a military confrontation is far from remote.

The latest inventory data also provided a jolt to oil prices. News that API inventories fell sharply last week boosted prices in early trading on Wednesday as it appeared to ease fears of a surplus.

But these one-off data points are trivial compared to the outcome of the Trump-Xi summit. Meanwhile, in the days following U.S.-China talks, OPEC+ will meet in Vienna, where it will likely extend the production cuts.

“An extension of the production cut agreement by another six months appears a done deal,” Commerzbank said in a note. “Russia’s Energy Minister Novak yesterday emphasized the success of collaboration so far and described international cooperation as more important than ever.” Related: The Last Truly Underdeveloped Oil Frontier In The Middle East

But an extension of the cuts is just the bare minimum needed to keep prices from falling. With the cuts already largely baked into oil price assumptions, there is likely little upside available to prices from an extension. Moreover, even as OPEC+ restrains output, they have significantly built back a measure of spare capacity. OPEC now has about 3.2 million barrels per day (mb/d) held in spare capacity, according to the International Energy Agency. “This is welcome news for consumers and the wider health of the

currently vulnerable global economy, as it will limit significant upward pressure on oil prices,” the IEA wrote in its June Oil Market Report.

In other words, while several major events affecting the fate of the oil market will take place in the coming days, only a major trade breakthrough has the potential to significantly boost oil prices. Secretary of Treasury Steven Mnuchin told CNBC on Wednesday that a trade deal is within reach. “We were about 90% of the way there and I think there’s a path to complete this,” he said. However, those comments should be taken with a grain of salt, especially since a trade deal appeared imminent multiple times over the past few months.

Absent a resolution to the U.S.-China trade standoff, the risks appear skewed more to the downside than the upside.

By Nick Cunningham of Oilprice.com

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