Abu Dhabi, UAETuesday 23 July 2019

Oil markets key to success of China’s crude futures ambition

China hopes that the Shanghai crude futures contract can create a new China-based global pricing point for crude oil

A VLCC oil tanker is seen at a crude oil terminal in Ningbo Zhoushan port, Zhejiang province.China is the world’s largest importer of crude oil. Reuters
A VLCC oil tanker is seen at a crude oil terminal in Ningbo Zhoushan port, Zhejiang province.China is the world’s largest importer of crude oil. Reuters

It’s been a year since China opened up its futures market to the world with Shanghai’s launch of a new crude oil futures contract hosted on a new exchange called the International Energy Exchange (INE). Designed specifically to attract international participants, China hopes that the Shanghai crude futures contract can create a new China-based global pricing point for crude oil alongside incumbent international crude benchmarks like Brent, WTI and importantly for Middle-East crudes going to Asia, Platts Dubai.

However, it is the market comprising buyers, sellers and financial traders who will ultimately decide.

The value of Shanghai crude futures reflects the price of medium sour crudes including Middle East grades Dubai, Upper Zakum, Oman and Basrah Light, stored in tanks close to refining locations on the coast of China. With China being the world’s largest importer of crude oil, the question is: can this futures contract become a reference used to price crude oil from the Middle East sold to China?

One might expect the price of Shanghai crude to be closely aligned to Platts Dubai, the main physical benchmark used to price much of the Middle East crude sold to Asia. But the price of Shanghai crude actually more closely follows that of ICE Brent futures which derive their value from light, sweet crude from the North Sea. One of the key differentiators of the Shanghai contract is that it is denominated in Chinese yuan not US dollars, which can affect the value of the derivative when expressed in US dollars. As the Chinese currency has strengthened against the dollar this year so the price of Shanghai crude when converted to US dollars has fallen by around two dollars a barrel against ICE Brent.

Virtually all the trading volume on Shanghai crude is on the current calendar or next calendar month where there are only a few cents between the bid and the ask – the price at which the market is willing to buy and sell the futures contract. This makes it easy to trade without significantly moving the price. But move just a few months down the futures curve where there is much less liquidity, and the difference between the bid and the ask can be over a dollar.

Both physical market buyers and sellers use futures markets to hedge and manage risk for physical oil market transactions. The lack of liquidity and market depth down the curve makes it hard to trade Shanghai crude much into the future without moving the price quite significantly. This hampers the use of Shanghai crude futures as a hedging tool for the physical market for now in this early stage of development.

The INE contract can be settled by physical delivery. This is usually by transferring ownership of a warrant - a receipt that allows the holder to take delivery of oil held in a specific tank – from seller to buyer. Liquidity on contracts that are close to settlement falls dramatically in the 10 days before expiry, as traders who are not allowed to take physical delivery are forced to liquidate their positions and roll them into the next contract.

The lack of volume on contracts near expiry means that prices near expiry can be relatively volatile when compared to financially settled derivatives. The market tends to observe the settlement mechanism of any new futures contract closely to evaluate its exchangeability to the underlying physical commodity market.

While the intention of the INE is to attract international participants, a year after its first trade it remains primarily a domestic affair. INE data from mid-December shows that around 92 per cent of the trading volume and around 80 per cent of the open interest was accounted for by domestic Chinese traders, and that retail investors accounted for slightly over three quarters of the volume and over half the open interest.

In its first year as a financial futures contract, the Shanghai offering has been successful in attracting liquidity. But the key challenges for Shanghai crude remain to attract international participants and build more liquidity and open interest further along the curve so as to be useful as a risk management tool.

The market will also want to closely scrutinise the physical settlement mechanism and the price volatility of the contract as it nears expiry. The INE has built the marketplace. If the oil market at large decides that a Chinese crude oil futures contract is needed, they will come.

Sebastian Lewis is S&P Global Platts' content director for China

Updated: April 18, 2019 08:23 PM

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