By Nick Cunningham, Oilprice.com:

Oil markets face a lot of downside risk – high crude oil inventories in both the U.S. and Europe, resilient production from U.S. shale, increasing output from OPEC, a nuclear deal with Iran, the turmoil in Greece – but one has not yet percolated through the markets just yet: the possibility of economic cracks in China, the largest oil importer in the world.

China’s economic growth has been cooling in recent years, with 2014 marking its slowest GDP growth rate in a quarter century. But that doesn’t signal anything is amiss. It is entirely unsurprising that the world’s second largest economy cannot keep up such a blistering rate of expansion.

However, deeper warning signs are starting to emerge. Part of that has to do with the extraordinary run up in China’s stock market over the past year, which is increasingly looking like a bubble starting to pop. The Shanghai Composite, an index of all stocks traded on the Shanghai Stock Exchange, had spiked by 40 percent so far this year and has doubled from mid-2014, and the Shenzhen Composite surged by a jaw dropping 90 percent since the beginning of 2015.

But the retreat could be on. China’s Shanghai Composite has plummeted over the past two weeks, falling around 25 percent. Fears that the bubble is popping appear to be spreading. Since June 12, the two exchanges have seen $2 trillion in market capitalization go up in smoke. The government has intervened, cutting interest rates authorizing state pensions to invest in stocks, allowing for nearly $100 billion to flow into the exchanges. That appeared to calm the markets as of June 30, which closed up nearly 5 percent.

Despite the rebound, China’s stock exchanges have suddenly been hit by extraordinary volatility – monthly trading volumes exceed six times the value of China’s $10 trillion market cap. The selloff is likely not over yet, and as concerns that the stock market is becoming detached from China’s slowing economy start to sink in, volatility will likely continue.

What happens next is unclear, but if China leans more towards a “hard” rather than “soft landing,” that would have negative repercussions for energy markets. Cracks that turn into wider fissures in the Chinese economy could lead to weaker demand for oil and gas, pushing down prices.

Dangers from China’s volatile stock market come on top of some warning signs about Chinese energy demand. A new report from the Australian government raises concerns over China’s tepid demand for LNG, of which Australia is one of the world’s top producers. China’s LNG consumption was expected to grow by more than 50 percent between 2014 and 2016, but “downside risks appear to be growing,” the report finds.

Much of that has to do with increased pipeline capacity from Central Asia, along with growing renewable energy, but weak demand stemming from a slowing economy is also contributing. For the first time since 2006, China imported less LNG in the first quarter of 2015 compared to the same quarter in the year prior.

Even China’s level of oil imports have looked shaky, before the latest market turmoil. In April, China’s oil imports hit a record high, but in May it dropped by 11 percent from a year earlier. Moreover, its imports could be temporarily elevated due to the government stockpiling oil for its strategic reserve. Once it stops buying for the reserve, its appetite could abate. China’s growth in oil demand has already started leveling off in recent years.

To be sure, the long-term fundamentals for China are compelling. China’s demand for oil and gas will likely rise steadily in the years ahead. And even in the short-term, the Chinese government could paper over the financial mess, putting a band aid on the problem. It has shown a willingness to actively intervene and further government stimulus in an effort to stop the freefall could inflate prices temporarily.

But the market turmoil in China presents a significant risk to global energy prices. By Nick Cunningham, Oilprice.com

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