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China bets on a yuan-oil bonanza

The country's long-delayed crude oil futures contract promises much, but doubts persist

The Shanghai International Energy Exchange (INE)—a child of the Shanghai Futures Exchange—continues to excite and frustrate domestic and international market participants over the launch of its crude-oil futures contract. Banks, whose market-making role would be crucial to the success of the contract, along with physical and financial crude-oil traders, are keen to trade on the INE. But continuing delays have frustrated some, while others debate just how much of an impact the contract could have on the international oil scene.

“We’re ready to go,” says the head of oil trading at a multinational bank, based in Singapore. “But we have been for months. Everything’s in place. We have clients at international energy companies telling us the same thing—their systems are all queued up.” In the view of the trading executive, “the applications could be astronomical, from trading directly on the exchange for hedging and China’s massive speculative market, to price discovery in yuan rather than in dollars. But the delays have just kept everyone guessing and running out of patience, to an extent.”

In H1 2017, China became the world’s number-one importer of crude oil at 8.55m barrels a day, overtaking the US, which imported an average 8.12m b/d over the same period, according to government figures. However, only around 2% of global oil is traded in yuan, with much of it traded even through China priced on other global benchmarks—mainly Brent and Dubai.

Politically, there’s a strong urge for the INE to launch the contract both at home and abroad. Domestically, the Chinese government would have a far greater say in the price of the oil it buys and sells, and internationally, Middle East players could be motivated to stop trading in dollars. Iran, for instance, could take advantage of the contract as a means to sidestep trading restrictions imposed by the US, while ties between Saudi Arabia and China continue to flourish. China is showing interest in the Saudi Aramco initial public offering, anticipated to go ahead sometime this year. Talks have been reported between Aramco and China National Petroleum Corporation. At the same time, Aramco is looking to purchase 30% of a CNPC-owned refinery for $2bn, further solidifying China’s long-term presence in global oil markets.

China’s central strategy is to seek secure oil flows as consumption continues to match economic growth. Energy security has long been at the fore, prompting changes to the energy economy over the past decade. Plans are afoot for further systemic adjustments—involving domestic sources of energy.

Diversity is key

More than 2.5m people work in China’s solar power sector alone, according to the International Renewable Energy Agency, and in 2016 the country became the largest producer of solar energy when it boosted photovoltaic capacity to 78 gigawatts as part of ambitious plans to target 105 GW by 2020. At the beginning of this year, the country’s National Development & Reform Commission announced plans to streamline its coal production by creating several “mega-miners”. These will have the capacity to produce 100m tonnes a year of coal, adding to its already substantial output.

Key to the energy security goals, however, is diversity, and the INE’s crude futures contract could be central. The head of trading at the Singapore-based bank, says China’s huge retail investor market will bring crucial liquidity to the contract. This would give it the potential to eclipse other, stuttering oil benchmarks—such as the Dubai Mercantile Exchange’s Oman Crude Oil Futures Contract (OQD) or the St Petersburg International Mercantile Exchange’s (Spimex) Urals crude oil futures offering. The trading boss points to the successful nickel contract launched by the Shanghai Futures Exchange in 2015. He believes the volume and volatility created by retail traders, and the interest shown by banks and domestic refineries will be enough to encourage international participation in the new oil contract, too.

There is interest from a number of sectors, but the INE has many factors to get right before the contract can gain traction

“It’s important to remember that this is going to be hosted in the Shanghai free trade zone, so it’ll be much easier for the international energy community to enter the market,” he says. “And with the volume expected from the retail sector, the presence of the teapot refineries, the international energy companies are going to be all over this.”

While delays over the contract’s launch have given domestic and international oil traders, and physical hedgers, time to get systems in place, they’ve also led to scepticism about the exact launch date. The oil futures were first proposed in 2012—when oil fluttered around $100 a barrel—but the INE has never announced a deadline. Rumours last year suggested the exchange was preparing the launch for end-2017. Other suggestions were for around the time of the Chinese New Year in mid-February, or later in 2018. According to state-run news agency Jiemian, the contract received approval from the country’s State Council in December, multiple rounds of testing have been completed and listing requirements have been affirmed. The INE didn’t respond to a Petroleum Economist request for a comment.

Slow take-up

But not everyone is convinced the market will be as swift to gather momentum as is being predicted, or that the requisite liquidity will be attained for the contract to be taken as seriously as the other main price-setting benchmarks. A senior member of Spimex suggests the contract could take time to get off the ground, based on their own experience and that of the Dubai OQD. When the Russian contract launched in 2016, the firm’s chief executive, Alexei Rybnikov, set a daily target of 10,000 contracts to be concluded. In the first six months of 2017 it achieved 3,200.

“I think a more interesting example is the Dubai Mercantile Exchange,” says the Spimex representative. “They spent five or six years from the launch of the product until it really started trading.”

He also suggests that the contract is “quite complicated” compared to WTI, Brent, the Urals and Dubai offerings: “You’re looking at several delivery points, several storage facilities, a mixture of several different grades and you can only go into the storage with a certain volume”.

Further, the official says certain cultural hurdles must be overcome in a domestic energy market when a major oil nation launches a futures contract. The Urals contract was designed for Russia’s energy sector to be able to hedge, but many of the larger players were initially reluctant. Before launching the contract, Spimex spoke to the physical market to assess the appetite of a ruble-denominated contract that prices could be set against and hedging positions made. That was before the oil price crashed, and producers told the exchange they had no need to protect against market risks. After the crash, however, attitudes changed, but Spimex had to canvas hard to convince companies of the benefits of the Urals contract. Now, it’s seeing substantially more interest, says the official.

Risk factors

However, it’s difficult to overlook China’s 10–12m retail traders who may be drawn to the contract. While those speculative traders could provide the contract with much needed liquidity, providing both sides of a trade for larger hedgers, if the market does take off and the price becomes volatile it could provoke government intervention. In 2016, with Chinese iron ore prices skyrocketing thanks to growing interest from the county’s domestic retail market, the government implemented stricter trading rules, shorter trading periods and higher fees. The possibility of a reoccurrence for the INE’s yuan crude futures is something banks and both domestic and international energy market participants will be wary of.

“It’s happened before,” says the Singapore-based head of trading at the multinational bank. “The government has seen a few swings in different commodities over the past few years and they’ve acted to adjust and protect those markets when they have seen a surge in volatility.” He adds that it’s “entirely rational behaviour to make sure a market doesn’t hit the dirt. But it also means market participants could be wary of government intervention when they’ve created long-term strategies around the contract. It’s not exactly healthy.”

2%—Volume of global oil traded in yuan

While short-notice government intervention is something energy companies will be wary of, sporadic changes to the structures of the other oil benchmarks has largely been welcomed. In early 2017, commodities price reporting agency S&P Global Platts announced it would include Norway’s Troll crude in the Brent pricing basket from January 2018, in response to a decline in the original basket’s productivity. Similarly, in mid-December 2017, the New York Mercantile Exchange—which hosts WTI and associated futures contracts—announced changes to its quality specifications, effective from January 2019. Both announcements were made in the context of keeping the contracts relevant to changing market conditions.

Whether those changes will help fend off competition from a yuan-denominated contract hosted in the world’s largest importer of crude will play out; but while there is interest from a number of sectors, the INE has many factors to get right before the contract can gain traction.

“Of course, there’s interest among the oil community,” says the bank’s head of trading. “This could be huge. But remember all the variables—the specs and size of the market when they launch it, prices elsewhere at the time of the launch, and the geopolitical risk factors, which can be both positive and negative, of buying and selling oil in yuan.”

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