China's Crude Oil Demand Could Drive Prices Toward Wartime Highs

China will play a pivotal role in deciding whether oil prices sustain this week's rally and potentially test wartime highs.

The U.S. crude oil price on Thursday topped $102 per barrel for its highest close since May. The futures contract surged about 50% from its summer low of $68.55 reached about three weeks after Washington and Tehran signed their now failed memorandum of understanding on June 17.

This week's rally comes as fighting sharply escalated in the Middle East with Saudi Arabia's crucial East-West oil pipeline shut down after multiple attacks.

The oil market has gradually restored a risk premium since the MOU collapsed and the U.S. reimposed its naval blockade of Iran in July, said Bob McNally, president of Rapidan Energy. But U.S. crude prices are still well below their April 7 wartime closing high of $112.95.

While the market has priced in the escalation in Middle East fighting, it may not have fully considered China increasing its imports, said Rebecca Babin, senior energy trader at CIBC Private Wealth.

"What isn't reflected is the fact that we may actually see a stronger demand pull for crude as refiners start to really try to ramp up in China, tightening the market further," Babin told CNBC's "Squawk Box" Friday.

China has played a crucial role in keeping prices from skyrocketing during the Iran war by acting as a swing consumer. It has slashed its crude imports between 3 million barrels per day to 5 million bpd, McNally said. Beijing has a massive petroleum reserve of more than 1 billion barrels it can rely on.

"The biggest factor containing crude oil prices since this thing started is China's crash diet," McNally told CNBC's "The Exchange" Tuesday. "It's coming off the diet and it's thirsty and it's hungry — it's starting to bid crude up."

Chinese refiners have an incentive to re-enter the market, as the profit margin to produce diesel has soared as the Iran and Ukraine wars have knocked out a significant amount of global refining capacity.

"Now that these refining margins are so extreme, they literally can't pass it up," Babin said. "They're going to buy crude and they're going to put product on the market and make money."

China's crude purchases are not expected to return to prewar levels but they have increased over those seen in the spring, said Amrita Sen, founder of Energy Aspects, in an interview with CNBC's "Access Middle East" on Friday.

China's imports plunged to a wartime low of around 6 million bpd in June, a nearly 50% decline compared with 11.5 million bpd in February, according to Kpler data. Its imports have increased to around 7 million bpd in July and August, according to the data.

China's buying activity this month is at a similar level to July and August and is unlikely to dramatically ramp up beyond that, said Matt Smith, director of commodity research at Kpler.

Beijing "is a very savvy buyer and will lean more on inventories and keeping refinery runs in check rather than buying oil in triple digits," Smith said.

But oil prices are trending higher as emergency stockpile releases are nearing an end soon. Global inventories have plunged by 400 million barrels after more than six months of war, eroding one of the other key buffers that prevented oil prices from shooting up earlier this year, according to the U.S. Energy Information Administration.

"Summer is over, peace didn't happen, the war is still going on," Rapidan Energy's McNally said, noting that the Trump administration's efforts to talk down the market aren't as effective as they previously were.

"The market's optimism bias, it's willingness to sell off on verbal intervention, jawboning about peace being around the corner, seems to be ebbing a little bit," he said.