China launched a yuan-denominated crude futures contract in March, possibly setting the stage for change in how oil is traded east of Suez
The Shanghai International Energy Exchange (INE) launched a yuan-denominated crude futures contract on 26 March, causing much discussion of whether this signals a direct blow to the Petrodollar or whether the contract’s use could feed the evolving trade spat between China and the US. But a closer look at what the contract is designed to hedge reveals another picture.
The idea that the use of the Shanghai crude contract could eat into business conducted on Nymex’s WTI crude futures or the Ice Brent contract is easy to overturn. Nymex WTI and Ice Brent are – as their names suggest by linking them to specific crude blends – reflective of light (low-density) sweet (low-sulphur) products. Though both contracts are used in the hedging of various kinds of oil exposures, they were designed to offer producers, traders and consumers protection against rapid changes in light sweet crude prices.
The Shanghai futures contract was designed with China’s crude import diet in mind and is therefore based on a basket of heavy crudes with relatively high sulphur content. Foreign crudes deliverable against the INE contract include blends produced by countries including Oman, Iraq and the United Arab Emirates, all of which are easily classified as heavy and sour. These crudes also bear a resemblance to blends that China imports in large volumes, including those from Iran, Saudi Arabia and Russia.
Another factor seldom mentioned in discussion of changes that could be brought about by the launch of the INE contract is that the heavier crudes refined in northeast Asia tend to be hedged using the Dubai crude swap mechanism. If any exchanges are likely to lose trading volumes as a result of the Shanghai contract becoming highly liquid, it will be those clearing Dubai swap trades and contracts that incorporate them.
Another factor seldom mentioned in discussion of changes that could be brought about by the launch of the INE contract is that the heavier crudes refined in northeast Asia tend to be hedged using the Dubai crude swap mechanism.
It is of course possible that China’s crude contract could feed into the import-tariff spat going on between the US and China, but it is more likely that the growing use of the Shanghai contract will instead deepen ties between China and those who sell it the majority of its crude imports, as Chinese buyers will be able to hedge exposures and make speculative trades in their own currency, removing the need for large-scale foreign exchange transactions and the additional hedging that those make necessary.
Russian ESPO
Russia is China’s biggest supplier of crude by volume and has become so because of the expansion of the Eastern Siberia-Pacific Ocean (ESPO) pipeline system. The system delivers medium-heavy ESPO Blend for shipment at Russia’s eastern Pacific port of Kozmino and delivers it directly to China by pipeline.
Russia supplied 1.32mn b/d of crude to China in February, showing a year-on-year increase of 18pc. This sharp rise in supply was caused by the opening in January of a second Sino-Russian pipeline, which doubled the amount of crude that China can take directly from the ESPO system.
Chinese buying of ESPO Blend rose in recent years following the Chinese government’s lifting of a restriction on the buying practices of independent or ‘teakettle’ refineries. Before the restriction was lifted, the teakettle refiners could officially only buy residual fuel oil on the open market. Once the rule was lifted, the independents took increasing numbers of ESPO Blend cargoes until Chinese refiners (state-owned and independent) moved into position as the main buyers, taking advantage of the fact that ESPO Blend loads in northeast Asia and therefore has a shorter delivery time and a lower freight cost than crudes shipped from elsewhere.
Any wholesale movement of liquidity into a new derivatives contract takes time, but the prevalence of Chinese buyers in the ESPO Blend market adds weight to the idea that the new contract could become the benchmark against which the majority of ESPO Blend is priced into China.
Liquid future
If the INE crude futures contract becomes highly liquid and starts to be used internationally, oil trading groups with Asia-Pacific desks are likely to find themselves seeking talent with specific China skills and experience. The process leading to this would involve the Shanghai contract, as used by Chinese traders and refiners, spreading out to become the go-to component in the pricing of heavy crudes into China, as well as in the east-west arbitrage trade that at present features Ice Brent crude futures and the Dubai crude swap. New markets take time to gather momentum, and the Shanghai crude futures contract is a market that we will be watching with curiosity.