Some weeks back, I’ve written about the potential impact of the arrival of the petroyuan, not just in the oil market but also in the currency market, and that such impact was going to arrive in the end of 2017. Nevertheless, as of now, things at the International Shanghai Energy Exchange (or INE for short) have been pretty quiet. So, what has happened to the yuan-traded Oil Spot and Futures market that could change the world?

For those looking for a fast answer, if we sail through the usual Chinese rhetoric, in summary we can see that pretty much their goals remained unchanged. If anything, the rhetoric remains ambitious, claiming the start of trading is just around the corner – on the 26th of March, according to the words of Chang Depeng – spokesperson for the CSRC (China Securities Regulatory Commission). And it’s about time!

The region needs a hedging benchmark

Both the WTI and Brent futures contracts, do not reflect the reality, demand-supply balance or even delivery conditions – ergo oil prices – in Asia. Because of this, and in the absence of a meaningful crude benchmark for the region, Asian countries end up paying larger primes than Europe and America for imported oil. In the case of China this additional cost may even reach $2 billion a year.

Also, not only has the Asia-Pacific region already surpassed America and Europe in crude consumption, but China has been mauling launching yuan crude oil futures for many years! It even set up a petroleum exchange in the early 90s, but soon ceased trading, due to the Reform and market conditions regarding currency and oil price.

As I mentioned in my previous article, although it will take time, this will also boost yuan’s global use, since global oil benchmarks are all quoted in US dollars. This means that China will increase even more its influence in the region and in the global financial system – particularly when compared to Japan and the mighty yen.

There are challenges though

Although it’s of undeniable strategic importance, creating a new crude benchmark is far from an easy feat – you actually need stakeholders to use it. And this is a big caveat. It’s easy to imagine that major trading cannot happen without pre-existing metrics, stable regulatory frameworks and confidence in the system.

Will Beijing promise to not affect prices (ergo trading margins) if the index doesn’t perform as they want when they want it? China is known for “endorsing” national stakeholders, in detriment of foreign ones, to the point of forcing them to partake in national endeavours. In this case, this would increase volume, but it might derail the interest of foreign day-traders. Right now, I bet hidden intervention will exist, since the way of Chinese state is to make things look “open” and “transparent” while keeping control of operations behind the scene. If not, let’s look at the storage that INE has approved to support this endeavour.

37.42 million barrels of storage capacity have been distributed across eight locations along the Chinese coast, as depicted in the infographic below. Nevertheless, as we can see, the State keeps overshadowing the entire process, with its NOC’s (National Oil Companies) controlling all (!) of the storage capacity: either directly through SINOPEC or SINOCHEM, or indirectly through subsidiaries of the State, such as PetroChina (part of China National Petroleum Corporation – CNPC), Qingdao (partially owned by Sinopec) or Yangshan (partially owned by PetroChina).

INE Crude Oil Futures Storage facilities

INE Crude Oil Futures Storage facilities
Source: Magnus CMD

Last, but not least, how will physical delivery constraints affect liquidity? It’s not common to find commodities traded in demand-owned geographic areas – and oil is no exception (just look at Brent, WTI or DME). Perhaps that is why China is adding Shengli-crude into the mix, as a representation of its own production (i.e. the northeast regions of Heilongjiang and Shandong).

Certification and Inspection will be conducted by CCIC (China Certification & Inspection Co.), SGS-CSTC, Shanghai Orient Intertek as well as the Shanghai customs. Here you can also find the hand of the state, with all companies involved maintaining strict ties with politics, even the ones representing multinational ventures.

But if it’s so important for China, where is it?

China’s commodity futures volume has been the largest in the world for 8 consecutive years now, with the Shanghai Futures Exchange (ShFE for short) – which owns the INE – claiming the title of the world’s largest metal futures market, while the Dalian Commodity Exchange (DCE for short) claims the title of world’s largest agricultural Futures Market.

However, back in 2015, the veteran Leo Melamed, chairman emeritus of the Chicago Mercantile Exchange, commented on China’s futures industry saying that it was about 80% speculators and only 20% hedgers, which is by any measure a very high ratio. In fact, this new attempt at the Energy branch of the Shanghai Futures Exchange was originally expected nearly six years ago but failed to launch as China’s market volatility raised severe concerns.

Nevertheless, as usual, China did its homework and claims to be now approaching 60/40, with the heavy hand of the Chinese State curbing the industry from pursuing trading volume alone (e.g., the DCE in 2017 investigated and dealt with 396 unusual transactions and suspended the opening of 148 clients).But this creates worries for traders, which may become afraid they won’t be able to freely exchange the yuan (due to excessive regulation on capital outflows) or even trade at will (due to the Beijing’s though market intervention).

It took three more years for the CSRC to approve oil trading in the INE, and two more until the proposal finally gained momentum. Freight costs will most likely be dealt with, perhaps using freight derivatives. To facilitate the entry of foreign participants, the INE will allow USD as collateral for initial margin. If and how gold will enter the equation, to support the yuan, remains to be seen or disclosed.

Nevertheless, back in the real world, platform tests keep delaying the initial date of trading. In early December 2017, the exchange conducted a trial run of futures trading and the respective market monitoring centre, in what is already its fifth market-wide crude oil trading system exercise (four similar exercises we’re held last summer). These exercises mainly simulated “usual-day” scenarios and cover pretty much everything: from major energy transactions, settlements, deposit and withdrawal, to hedging (arbitrage), data submission and quotation forwarding.

According to INE’s information, a total of 149 members participated (including 144 futures companies and 5 non-futures companies) exchanging 56.671 contracts of crude oil futures in 90.564 trades, reaching a total volume of 647.930 traded lots (with each lot containing a thousand barrels). This amounted to a turnover of 268.2 billion yuan (i.e. the modest amount of 42.3 billion USD), or what can be translated to an average 65,28 USD/bbl.

In light of the recent success, perhaps it’s safe to assume they are right when claiming it may actually be around the corner. We’ll be keeping you posted in our recent created twitter handle @mtechinsights and you’ll be able to find market data from INE in as soon as trading goes live.

Hugo Martins |Analyst

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