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China's Most Powerful Weapon In The Trade War

China US

President Donald Trump’s first year in office must have been a pleasant surprise for Chinese President Xi Jinping. A successful state visit in Beijing and an apparent personal chemistry between the two leaders suggested a close relationship between the countries was brewing. But President Trump’s second year has turned that narrative on its head. The trade war between the two largest economies in the world has been intensifying of late, with both countries implementing a second round of tariffs on $16 billion worth of goods.

It has been one of Trump’s main goals to reduce the U.S. trade deficit with China. The shale revolution in the U.S. has shrunk the deficit slightly, with China requiring ever-larger volumes of oil and gas to power its economy. In an attempt to avert a trade war, Beijing proposed to buy nearly $70 billion of American products of which LNG was an important part. The U.S. administration turned down the offer and chose instead to implement the first batch of tariffs, hoping to squeeze more out of China.

After its proposal was denied by Washington, Beijing threatened to include oil in its list of tariffs, which obviously affected prices. However, the fundamentals of the oil market made the Chinese reconsider. China has seen a 200-fold increase in its import from the U.S. in the past two years (see below). Despite the impressive rise, it still accounts for just 3 percent of China’s total imports. However, the light sweet characteristics of American oil compared to the medium sour of other suppliers and the discount at which it is being sold, makes it an attractive product. Other customers in the region could easily fill the gap created by Chinese customers meaning that the tariffs would affect Beijing more than the U.S.

It is another story for LNG. While oil is conspicuously absent from the proposed list of tariffs of present and possibly future products, LNG undoubtedly remains an option. China’s shift towards more environmentally friendly policies and its goal of doubling natural gas to at least 12 percent of its energy mix, has made it quickly emerge as a significant player in the market. Related: What Is Bakkt And Can It Take Bitcoin Mainstream?

The potential LNG glut was forecast to persist until 2022, but Beijing singlehandedly changed the fortunes of producers with a massive increase in imports. China has already surpassed South Korea to become the second biggest importer of natural gas and, according to the IEA, the country is set to become the largest importer next year.

(Click to enlarge)

The effect of tariffs on U.S. LNG could be significant as it would obviously raise the cost of transporting the super-chilled natural gas to Chinese customers. Despite American exporters being the sixth biggest supplier of LNG at the moment, impressive growth and overabundance of natural gas in the U.S. provide it with even more supply for global customers. For every 175 units being produced, just 100 are being consumed in America while 75 percent is available for export. Furthermore, the enormous potential of China in terms of growth makes it the most important future market for LNG. The situation seems ideal for both countries, but tariffs may soon change that.

(Click to enlarge)

In the short-term, tariffs are likely to simply shift the global LNG market. When China decides not to buy LNG from the U.S. and instead purchase from alternative sources, other consumers are likely to act in the opposite direction. However, the factors that made Beijing reconsider its threat regarding crude oil (the discount of U.S. product and higher quality) do not apply for LNG where the cost of transportation rises significantly with distance and quality is not an issue.

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When it comes to investment decisions, the current conflict could not have come at a worse time for the U.S. Several U.S. companies are competing to construct additional LNG facilities on the Gulf of Mexico, each of which will require years of construction. The imposition of tariffs on American LNG could delay a decision to construct gasification facilities while aiding competitors in other regions as most LNG is secured on long-term contracts.

Besides the U.S., other major exporters such as Australia and Qatar are looking to expand their production capacity. Woodside Petroleum, Santos, and Oil Search are targeting the final investment decision on three projects worth $35 billion in Australia. Qatar intends to increase production from 77 million tons to 100 million. Russia, on the other hand, is on the brink of completing a multi-billion-dollar pipeline in the northeast with the second string under negotiations in the northwest. All producers are aiming for China and any decision concerning American LNG would strengthen their position.

The imposition of tariffs would significantly impact both the U.S. and China. in the short-term Beijing risks being exposed to supply crunches especially during the winter period. The U.S. on the contrary is shielded for the short-term due to long-term contracts. However, as decisions to expand export capacity have to be made in the near future, losing out on the most important LNG market is not reassuring for investors. Despite Donald Trump’s claim, trade wars are dirty and risk damaging all parties. Energy trade between the U.S. and China is not an exception.

By Vanand Meliksetian for Oilprice.com

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