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China seeks to solidify oil future

The successful launch of the long-awaited Shanghai oil futures contract showed it is gaining sway in global energy markets

After nearly six years of speculation, rumours and declared intentions, the Shanghai International Energy Exchange (INE) finally launched China's first-ever oil futures contract on 26 March.

It comes at a crucial time for domestic oil demand. February inventory-adjusted demand was up 660,000 barrels a day year-on-year, while production averaged 3.76m b/d in January and February, according to the China State Statistics Bureau. That's down 130,000 b/d—or 3.4%—year-on-year, almost flat from December figures and level with August 2017's record lows. Those figures suggest that the Shanghai futures contract couldn't have been better timed: with the INE contract open to international market participants, China's ruling party, aware of a growing reliance on international oil markets, hopes to edge greater sway in oil prices.

Last year, China became the world's biggest crude importer, thanks to growing domestic requirements and the US relying more heavily on its own shale output. Should the contract attract enough liquidity over a sustained period, it could help China gain pricing power in oil markets, while further internationalising the yuan. The country has made it a long-term goal to promote the use of the yuan as the currency of choice, not just for oil markets, but for all kinds of trade. China has also identified the benefits of having a contract based on the grades of oil consumed most by its teapot refineries, while offering domestic players a deal that removes foreign-exchange risk.

Last year also saw adjustments made to the composites of the Brent and WTI contracts, seen in some quarters as positive steps to modernise them—and in others as attempts to paper over the fact the two most relied-upon global benchmarks must change in order to retain their relevance.

Closer Saudi ties

China imports most of its oil from Russia, and has established, long-term crude agreements with Saudi Arabia. The kingdom has invested heavily in China and relations between the two countries are likely to become even closer. With the Saudi Aramco initial public offering supposedly on the horizon, there are rumours that the Chinese are interested. There is a strong likelihood that at least some of the shares will be listed on the Hong Kong Stock Exchange.

3.76m b/d—China's January--February crude oil production

Liquidity was strong for the contract on launch day, with 40,656 contracts worth around 17.64bn yuan filtering through the system, according to the exchange's figures. Speculators and hedgers would have shown interest, with the most active September contract settling at 429.9 yuan (around $68) per barrel, and fluctuating between 426.3 yuan and 447.1 yuan during the course of the trading session.

Before the launch went ahead, many domestic and international market participants—both speculative investors aiming to make a profit and oil companies looking to mitigate risks taken in oil markets—might have been forgiven for expressing scepticism. The contract's launch date had been delayed, as a personnel merry-go-round seemed to occur at the exchange's top echelons, in step with the country's wider economic deliberations. At the same time, those market participants not involved in China's oil markets debated the need for yet another exchange's attempt at a global benchmark, with Brent and West Texas Intermediate the stable, widely-accepted price setters for oil transactions across the globe.

Causes for concern

Indeed, many analysts suggested that the Chinese political hierarchy would get in the way of the potential success of the contract. In the past, where a commodity futures contract has been deemed "overheated", Shanghai has stepped in. The intention was to slow markets down in order to isolate what was considered to be too much risk with a contagious threat to the rest of the financial system. That, and the country's decision to overhaul market regulation based on assessments of the wider national markets, have traditionally been considered cause for uncertainty for any Chinese contract. They remain valid concerns.

But the months that led up to the contract's eventual launch looked more and more timely for the INE to push it out. In 2017, the government announced plans to open up its financial system to international market participants, with a range of reforms, including the means by which institutions and individuals can access and trade yuan. It was also a year that saw the domestic speculative market hit new heights in trading activity, growing at an apparently acceptable rate that didn't require government officials to intervene.

In taking such a long time to refine the contract, the INE has attempted to build robust trading infrastructure around it: there are limits on the number of cancelled orders to eradicate spoofing—the act of placing then cancelling a trade in an attempt to force the price in a certain direction. Trading is carried out during three established periods per day, and there will be longer delays during national holidays. The rationale behind these decisions is to both concentrate liquidity, and increase transparency in the nascent market.

Global acceptance needed

All that points to a robust, liquid, and attractive contract. But international market participants will no doubt have reservations, and China's place on the world energy stage is by no means concrete. While the efficacy and liquidity of the contract could no doubt be supported by China's massive domestic speculative market, its status as an international—if not regional—oil benchmark will be based on its acceptance on the global playing field.

Wider political and economic relations have become strained of late, with the US imposing tariffs on around $50bn worth of Chinese goods and Beijing threatening to retaliate in kind. The trade battle between the two countries is unlikely to come to a conclusion any time soon: on 5 April, the White House said that President Trump had asked the US Trade Representative to consider targeting an extra $100bn of Chinese goods to face tariffs. Should relations not thaw, it could have defining impacts on both countries' oil economies, say analysts.

China has made it a long-term goal to promote the use of the yuan as the currency of choice, not just for oil markets, but for all kinds of trade

"The US and China are the world's largest oil consumer and oil importer countries," wrote commodity analysts at Commerzbank, in a report. "If the trade conflict escalates and slows oil demand in the US and China, this would have an impact on the market balance that could hardly be ignored."

While China's long-awaited crude futures contract has started strongly, it requires patient domestic custodianship by the INE, while remaining free from interference or price setting. Commodity traders may well be wary of Shanghai's interference in nickel contracts: listed in 2015, within six months trading volumes in Shanghai overshadowed that on the market's established benchmark setter, the London Metal Exchange. As Chinese investors buoyed liquidity, prices rose and the government stepped in, enforcing tighter trading rules, higher fees and restrictive trading hours.

The contract also needs the unrestrained support of international market players, free from political interference, in order to become established, and take a foothold in international energy markets. While that doesn't solely rest in the hands of the US, other energy players—including Europe—will look at strengthened relations with Washington as an imperative.

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