It's a riddle that might have confounded Confucius: Will China's surprise currency move shift the engine of growth in world oil demand into higher gear or tap the brakes to slow surging consumption?

Oil prices rose 2% early in reaction to China's moves to loosen its exchange rate, but analysts said the knee-jerk reaction faded, as costlier exports may slow exports, reducing the manufacturing sector's oil needs. In an oft-played scene, oil markets are trying to puzzle out the impact of policy shifts in the world's second-biggest oil consumer, expected to account for about 40% of growth in global oil demand this year.

The oil market may have over-simplified the impact of the currency move, seeing only the potential for lower fuel prices at the pump for China's ever-increasing numbers of automobile owners.

"Traders take the view that oil has been re-priced lower in local terms to domestic Chinese consumers," said analyst Paul Sankey at Deutsche Bank. "In fact, Chinese oil product prices are controlled and part-linked to international crude prices, so will not necessarily fall."

Sankey said the bank left its forecast for 2010 growth in Chinese oil demand unchanged at 700,000 barrels a day. "This move may provide a short-term driver to oil markets, but they remain essentially well-supplied," he said, adding it maintains a below-consensus oil-price forecast this year of $71 a barrel.

China announced over the weekend it is effectively ending an informal peg of the yuan to the dollar, but without a direct revaluation of the currency. That dollar peg fueled a surge in Chinese exports by keeping them cheap, but that agitated the U.S.

Jun Ma, Deutsche Bank's chief economist for China, said in report that if the dollar is stable against the major currencies, the move would imply a 3% to 4% annual appreciation in the Chinese currency, which is "less aggressive" than the bank had forecast "as rapidly growing wage inflation ... will also reduce China's export competitiveness." Ma expects the move to cut gross domestic product growth by 0.2% annually and reduce export volume growth by 0.7%.

"The economy [exporters] will slow, but domestic consumption will increase ... this could mean more cars on Chinese roads; but manufacturing growth may be slower," David Hurd, the bank's China-based oil analyst, said in a note distributed by Sankey. "The net effect is probably not that great."

Analysts don't see the currency move curbing Chinese petroleum-products exports.

Paul Ting, a U.S.-based independent analyst specializing in China, said a stronger yuan-dollar exchange rate would reduce Chinese oil import costs, but this would likely be gradual. "The perception may be more important than the physical market response" in pushing up oil prices, he said. But the stronger yuan "can gradually increase China's downstream margins," which will provide incentives to produce more petroleum products.

Ting expects Chinese oil demand to grow by about 775,000 barrels a day, to 9.1 million barrels a day, which is still less than half of world-leading U.S. oil demand.

"The currency strength actually serves to increase downstream [refining] margins, and as such, will relieve the pressure for China to increase domestic prices," Ting said. "Directionally, this should help China to depress inflation." But, he said, if this results in higher domestic demand--or an oil market perception of a higher demand--it could lead to upward pressure on global oil prices, and renewed inflation worries.

"One should not expect a massive oil-price increase, but the currency-inflation-price-demand loop is bullish for oil prices," he said.

Source: Downstream Today