Could Chinese Oil Futures Disrupt the Market?

Could Chinese Oil Futures Disrupt the Market?

Could Chinese Oil Futures Disrupt the Market?

The over 25 year wait for Chinese oil futures ended at exactly 9am Beijing time on Monday, 26 March 2018, as crude oil contracts began trading on the Shanghai International Energy Exchange. The reference price was set at 416 yuan, but September settlement futures opened trading at 440 yuan. Currently, the London’s Brent Crude and US’s West Texas Intermediate (WTI) have dominated the crude oil futures market, but with its new-found status as the largest importer of oil, China’s oil futures may well provide the formidable challenge the two traditional benchmarks have lacked over the years.

Why China Launched its Oil Futures Now

The idea to have oil futures trade on the Shanghai International Energy Exchange has always been there for a long time. In 1993, domestic crude oil futures were actually launched, but they were stopped a year later due to volatility. That need arose again in 2012 when oil prices spiked past $100, but volatility concerns remained. In 2017 though, despite average prices of $50, the need was more urgent as China became the world’s single largest importer of oil.

It was high time the Chinese oil industry had a local hedging tool, while the country also stood to derive benefits of having a benchmark reflecting the oil grades consumed by Chinese refineries. Politically, China will also make a significant stride towards promoting the use of the yuan in international trade. And while oil futures are the start, the long-term goal for China is to boost the yuan’s profile in the pricing of commodities. The potential for this is great, considering that the last time China listed a commodity was 2015. That was nickel, whose contracts outstripped the benchmark futures listed on the London Stock Exchange within just six weeks.

How Shanghai Oil Futures Will Work

They will operate just like the standard futures market. Basically, commodity futures contracts fix prices today for a delivery scheduled at a later date. Futures contracts are very important for both consumers and speculators: the former utilize them to protect themselves against possible higher future prices, while the latter use them to bet on future price direction.

Shanghai oil futures will be available for trading 9am – 11:30am in the morning; 1:30pm – 3pm in the afternoon; as well as 9pm – 2:30am at night, Beijing time. Margin requirements have been set at 7 percent, while the daily trading band was set at ±5 percent and 10 percent on its debut day. The Shanghai oil futures contracts will have 36 delivery months, with the first 12 months as rolling contracts.

Impact of Chinese Oil Futures on the Oil Market

There have been numerous false-starts with Chinese oil futures in the past. This time though, the contract has been backed by approval from the China State Council. Already, the talk in financial circles is that the prospect of ‘petroyuan’ is more real than ever. As the largest importer of the commodity, China cannot be overlooked now. The Shanghai oil contracts are settled in yuan, which essentially means that they are not settled in US dollars. This consequently reduces the demand for dollars.

There is a strong case that the energy complex has been one of the significant contributors to US dollar strength. It is still early days to suggest that China might upset this, because, while they are the single largest importer of oil, its consumption accounts for only about 13% globally. In terms of consumption again, they still trail both the US and European bloc. This simply means that China, as yet, does not enjoy enough clout to stage an oil coup.

But there are encouraging signs. China will be massively involved in the upcoming IPO of Saudi Arabia’s biggest oil company, Saudi Aramco. This could at least encourage the Asian giant to consider accepting yuan for its oil. Furthermore, there is an agreement between China and Russia, another oil producing nation, to transact using their local currencies. The petrodollar is deeply entrenched in the oil ecosystem, but it is entirely not unreasonable to imagine a future where the petroyuan will at least be a solid, if not a dominant, player.

The US vs. China

Ultimately, a strengthening yuan will mean a weakening dollar. This will be good news for China as an oil importer. But aside from oil, China is a big exporter. On the flip side, the US is aiming to be an oil exporter, which on the surface means that a weakening currency would favor its pricing in international markets. But away from oil, the US is a big importer. This sticky situation makes investors think more about the tariffs between China and US that are threatening a trade war. This has been the mainstay headline in financial markets currently. It is very likely that the genesis of all this has been the settlement of oil contracts in yuan.

Already, investors have warmed up to the Chinese oil futures, recording a turnover in excess of 18.3 billion yuan (about $2.9 billion) on the first trading day. With China now in the market, trading oil might just never be the same again!

 

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