China's Oil Slurping Elephant in the Room

Oil supply is looking increasingly comfortable this year after a series of downgrades to demand forecasts. But don't get too excited about lower oil prices just yet. First, it's worth taking a look at the oil slurping elephant that China has just led into the room–the second phase of its half-billion barrel strategic petroleum reserve.

China showed in 2009 that it will exploit slumps in the oil price to fill this beast, and the International Energy Agency said Friday that the Asian giant could do so again this year if prices fall, potentially offsetting much of the loss of oil demand due to economic problems in Europe.

The IEA cut its oil demand growth forecast for 2012 for the second time Friday in just a few weeks. The agency now sees oil demand expanding by 0.8 million barrels a day this year, 0.3 million barrels a day lower than forecast last month [].

With OPEC oil production at its highest level since October 2008 and demand weakening, shouldn't consumers expect lower prices in the future? Perhaps not.

There are several factors still supporting oil prices at "stubbornly high" levels, including well known issues like the standoff between Iran and the West and supply disruption in South Sudan, the IEA said. Less well discussed is how the newly-constructed second phase of China's Strategic Petroleum Reserve could materially increase its demand this year.

Given that China accounts for half of world oil demand growth, this isn't something that can be ignored.

China will finish building new oil stores with capacity of 79 million barrels this year, the IEA said. If it were to fill these gradually over the year it would add 220,000 barrels a day to oil demand, equal to the amount the IEA just trimmed from European oil demand.

In reality, the impact this will have on the oil market will be much less predictable than that.

David Fyfe, head of the oil markets division at the IEA, said:

"The Chinese are always very astute in picking their time."

He added that if prices were to weaken considerably, China's purchases could increase by a multiple of that 220,000 barrel a day figure.

Last month, Goldman Sachs said that China could absorb as much as 550,000 barrels a day of oil into its reserve if market conditions were right–perhaps if Iran was offering discounted oil that had been banned by Europe.

The lack of clarity on this issue will be a genuine wild card for the oil market this year.

Goldman's oil analysts said:

"Unfortunately, the Chinese government doesn't provide data on its strategic stockpile program and the available information is sometimes contradictory."

Nobody has a clear idea of what the Chinese government is planning and the IEA certainly wouldn't try to predict its actions, said Mr. Fyfe.