China Shakes-Up Crude Oil Trading
On March 26, 2018, China’s long-awaited yuan-denominated crude oil futures launched on the Shanghai International Energy Exchange (INE) in a landmark move intended to shake-up the well-established crude oil trading landscape, and potentially the U.S. dollar’s worldwide currency dominance.
Today, the world has three main oil benchmarks: Brent, quoted on the Intercontinental Exchange; West Texas Intermediate (WTI), quoted on the Chicago Mercantile Exchange; and Dubai-Oman, a less-prominent benchmark, quoted on the Dubai Mercantile Exchange. These benchmarks accurately represent the grade, or quality, of the oils transacted in the markets that they govern as well as the supply-demand dynamics of these markets, allowing regional and local transactions to be reliably priced against them. In addition, they are quoted in U.S. dollars, the world’s primary reserve currency, facilitating efficient market function. The specific grades that these benchmarks represent are available from myriad producers. These factors create a highly liquid market (thanks to the ubiquity of financial speculators) that allows commercial participants to effectively hedge risk factors, such as price volatility.
China, the world’s largest energy importer, has created a potential new benchmark that better reflects the quality of oil transacted in the East Asian market. The yuan-denomination will allow Chinese commercial participants to hedge risk while paying in domestic currency which, in turn, will give the country more leverage to price global energy supplies. A prudent move for China given their ever-accelerating dependence on foreign oil (last year China surpassed the U.S. as the world’s largest crude oil importer). Moreover, the INE is located in Shanghai’s free-trade zone, enabling foreign participants to invest in a Chinese commodity derivative for the first time.
China’s open-trade derivative debut represents a conspicuous attempt to wrangle a degree of price control away from the U.S. dollar while simultaneously internationalizing the renminbi, of which the yuan is the unit, in the global market. This has triggered much conjecture amongst the financial community that, if the contract were to become successful enough, it could become a legitimate benchmark to grades distinct from Western contracts. Even further, if the contract gains enough traction amongst investors to the degree that demand swings from the U.S. dollar to the renminbi, the latter could usurp the former as the world’s dominant petro-currency.
Although the new crude futures market has been widely considered a success to date, with its average daily volume rising 147% in May over April,(1) retail and financial investors make up the bulk of the trades, satisfying only the liquidity requirement of benchmark formation. Further, China’s tendency for market intervention and capital controls may be an impediment to the benchmark’s success. Additional obstacles include INE’s high fees and margin requirements, exchange rate risk and the appetite for hedging the yuan against the U.S. dollar, as well as off-kilter trading windows.
Is this move by the Chinese the beginning of the end of the U.S. dollar’s petro-currency dominance and another step in China’s drive to replace the U.S. dollar with the renminbi as the world’s primary reserve currency (as the U.S. dollar replaced the pound sterling after World War II)? … We encourage everyone to stay tuned …
(1) S&P Global Platts, China’s Crude Oil Futures Market Liquidity Hits Record High in Early June, June 5, 2018.