The launch of China’s oil futures contract last Monday marks the biggest shake-up in pricing crude for years.
Grandiose claims have been made for it – that it will entirely transform oil price determination, or even lead to dethroning the dollar as the world’s reserve currency. However these scenarios turn out, this new contract does create concern for the Middle East countries and their premier export.
World oil pricing has long been based on two benchmarks: Brent crude from the North Sea, quoted on the Intercontinental Exchange, and West Texas Intermediate (WTI) in the US, on the Chicago Mercantile Exchange. Both are light, sweet (low-sulphur) oils, freely traded in dollars, and available from a wide range of producers. Deep and liquid futures markets allow participants to hedge their risk – whether an oil producer seeking to lock in higher prices, or a refiner ensuring its feedstock cost does not escalate. This activity is helped by the much-maligned “speculators”, who provide liquidity, and may themselves be seeking to lay off macroeconomic risks correlated to oil.
Both markers have problems. WTI is a land-locked crude with constrained pipelines to reach world markets, while US output increasingly comprises very light oils from shale that do not easily suit refineries. Brent production from the North Sea has long been declining, requiring more and more grades from other fields, some very different in composition, to be added to the physical basket that underpins it. And local accidents to ageing infrastructure – such as December’s shutdown of the cracked Forties pipeline – disturb global prices.
The third major benchmark, Dubai-Oman, is for sour (high-sulphur), medium-gravity crude, much more typical of Middle East production and of the grades sought in Asia, the centre of world demand growth. The Dubai Mercantile Exchange (DME) is the venue for trading Oman crude futures. These closely track the physical Dubai crude (which, confusingly, can also be substituted with Omani crude or Abu Dhabi’s Upper Zakum), whose price is assessed by specialist agencies and is the basis for most Middle East oil sales to Asia.
Since its launch in 2007, DME Oman has grown to be the world’s largest physically-delivered oil futures contract, but the quantity of financial trading still lags well behind Brent and WTI.
The new Chinese contract is distinctly different. Trading on the Shanghai International Energy Exchange (INE), it is denominated in yuan, and based in what is now the world’s biggest oil importer. Seven crude oils are deliverable against the contract, specific grades from Dubai, Abu Dhabi, Oman, Qatar, Yemen, Iraq and China’s own Shengli.
Notably, Saudi Arabia’s Arab Light is not on the list, despite its good fit for the specifications. Neither, even though Russia is China’s largest supplier, is East Siberian pipeline oil, too light and sweet to match the other crudes.
Why would the Chinese want to launch such a contract? It should better reflect the crude quality and supply-demand dynamics in the East Asian market than do the distant Brent and WTI. And it is part of China’s drive to trade more in its own currency, the yuan, as it has also been pushing with its Belt and Road infrastructure initiative throughout Asia.
Oil makes up some 10 per cent of world merchandise trade, but ideas that this contract will dethrone the dollar as the world’s premier currency are overstated. Major shifts in global reserve currencies take time and often require dramatic political and economic realignments, as in the post-Second World War changeover from the pound sterling to the dollar. The dollar is losing ground to the yuan (and euro) but the yuan is still not freely convertible.
For now, INE’s higher fees, higher margin requirements, restrictions on crude imports into China, the need to hedge the yuan against the dollar, mismatched trading times and closure during Chinese public holidays are all deterrents to its wider take-up by outside traders.
On its first few days, the Shanghai contract has traded about four times the volumes of the DME, but its open interest, a measure of hedging, is still much lower. If this persists beyond its infancy, it would point to INE’s use for speculation rather than by commercial players seeking to avoid risk.
DME signed a cooperation agreement with INE in 2014. In principle, as they are based on similar underlying crudes, their two contracts should trade very similarly, the difference between them reflecting just freight costs from the Arabian Gulf to Asia. Based on very limited data, this is borne out so far, with INE above Oman and below Brent.
In this case, Middle East oil producers have nothing to fear, and INE may become an acceptable way for them to price their crude sales to Asia, even boosting its value by allowing easy hedging. Iraq has begun selling some of its crude by auction through the DME, but other than from Oman, most Middle East oil sales remain heavily restricted on permitted destinations and resale, limiting its value to traders.
But the Chinese government may interfere more heavily in the INE contract, to subdue volatility, dampen price spikes or simply move the market in ways it desires. Then the Middle East oil exporters may come to regret having lost control of the pricing of their key commodity.
Robin M Mills is CEO of Qamar Energy, and author of The Myth of the Oil Crisis