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China oil futures – the dawn of a new petrocurrency

China is poised to launch its own oil futures on 26 March denominated in Chinese yuan. Given the increasingly large volumes of crude oil it imports, there is a possibility that in the longer term a successful futures contract might devolve into a fully-fledged benchmark to price crude exports to China.

Some of the world’s oil supply would subsequently be priced in yuan, enticing some producers to please their largest buyer and adopt the Chinese national currency for physical oil transactions.

If anything, this would challenge the supremacy of the US dollar as the world’s main petro-currency.

China has become a key driver of the global oil markets, given its rising oil imports, which neared 300m bbls in January, almost double the imports recorded in November 2013.

The long-awaited crude oil futures contract will be launched on the Shanghai International Energy Exchange (INE) – a branch of the Shanghai Futures Exchange.

Yuan-denominated crude futures will enable Chinese crude oil buyers to hedge their prices and pay in local currency.

Seven medium sour crudes will be deliverable into the new contract, including six Middle East grades plus home-produced Shengli.

And because the exchange is registered in Shanghai’s free trade zone, foreign traders will be allowed to invest, which will be a first for China’s commodity markets.

Like the Urals futures for Russia, a crude contract priced in yuan has long been in China’s mind, especially in light of the huge volume of oil it imports.

Like Russia, China made a previous attempt to introduce oil futures in 1993, only to stop trading them one year later after levels of volatility became unmanageable.

Price fluctuations were then so wide, and prices so volatile, that hedging through the contract was more risky than not hedging at all.

Since then, the launch of a new contract has been repeatedly delayed by financial hurdles, in particular the turmoil in global equities and financial markets following the 2008/09 crash.

However, the increasingly large volumes of crude oil imported by China have given the project a new boost, especially as it may increase the country’s clout in the global oil market by wresting pricing control from the established, US dollar-denominated oil benchmarks.

The decision to create its own domestic oil futures is rooted in China’s ambitions to increase its bargaining power to price energy supplies amidst an increasing reliance on oil imports. And a Chinese benchmark would help promote the use of the yuan in global trade.

It would also more fittingly reflect the grades that are purchased and processed by domestic refineries.

There is a long way between the launch of an oil futures contract and its wider adoption and success as an international benchmark.

Liquidity and a high market turnover will not necessarily transform it into a new, global oil index, not to mention a regional one.

For the contract to succeed, there must be a commercial need for hedging, which is probably the case.

In addition, a pool of speculators must be attracted to the market, and the political and regulatory environment must be conducive to futures trading, both of which might be lacking at present.

Volatility – also known as systematic risk – will also have to be tightly reined in. Because this risk is inherent to the entire market, it is very difficult to diversify away, especially when dealing with a primary source of energy like crude.

Global success is not impossible though, the country having a track record of successful commodity futures with the introduction of its nickel futures in 2015..

Six weeks after its introduction in March that year, the trading of nickel (the metal widely used in electric batteries) in Shanghai had surpassed that of benchmark futures on the London Metal Exchange (LME).

China’s local markets have strongly replicated the moves of the LME, with the difference being that speculators in China have a far greater role than on western exchanges.

Speculative buying into nickel could be propelled by an incrementally more constructive China, and the same may therefore hold true for domestic oil futures in light of rising crude imports and global growth.

In a 30 January note, the head of commodity research at Citi Group, Edward Morse, and his team indicated that commodities had become a better home to Chinese ‘hot money’. As a result, “Chinese investors are now seeking domestic investment opportunities, as the sell-off in USD seems to have more room to go,” they wrote.

Key oil exporters to China like Iran and Russia have already agreed to transact in yuan terms. If the demand for renminbi came at the expense of the US dollar, there is always a chance, however slim, that the Chinese yuan could displace the US dollar as the main petro-currency.

Because China will remain a key buyer, it makes sense to look at transactions in renminbi, at least in the longer run. However, before that happened, the yuan would have to clear a few hurdles, starting with the globally-entrenched practice of paying for oil in dollars.

The yuan is used in only about 2% of global payments. Oil futures may help China’s push for the internationalisation of the yuan, but their success as a benchmark will hinge critically on the degree of capital control exercised by the state, especially on the flows related to the futures contract.

China’s penchant for occasional market intervention and capital controls may stand as a major impediment to the participation of foreign investors. After a steep 2015 devaluation prompted large capital outflows, the Chinese state tightened the restriction on the movements of money in and out of the country.

The yuan appreciated by about 6% against the US dollar in 2017, recouping its previous losses and showing continued strength.

Market consensus points towards further appreciation of the yuan, the People’s Bank of China having recently pushed up its rates to align with the US Federal Reserve.

The current trade tensions with the US may also help the yuan’s strength.

China is keen to contradict the traditional belief that it has been intentionally making its currency weaker to gain export advantages to avoid further deterioration of its trade imbalance with the US.

This is good news for China’s oil futures. In the meantime, Chinese regulators have made clear that they want stability in the financial markets.

The difficulty for the country will be to find the delicate balance between gaining price influence in the global oil market and, at the same time, avoiding excess foreign exchange volatility.
Source: By Julien Mathonniere, ICIS (https://www.icis.com/resources/news/2018/03/16/10203382/insight-china-oil-futures-the-dawn-of-a-new-petrocurrency/)

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