The Fuse

China’s Crude Benchmark Delayed, Still on Track to Take Off

by Matt Piotrowski | April 04, 2016

China’s new crude oil benchmark, which is poised to rival NYMEX and ICE, has yet to kick off, posing doubts whether Asia will soon see an established marker as it continues to be the main engine of demand growth in the global oil market. Regulatory turf wars, disputes over the eligible crudes for physical delivery, and a sharp downturn in trading in a number of markets in the region have delayed the benchmark’s opening, a source familiar with the benchmark’s progress tells The Fuse.

Regulatory turf wars, disputes over the eligible crudes for physical delivery, and a sharp downturn in trading in all markets in the region have delayed the benchmark’s opening.

Moreover, China wants the benchmark, which will be a yuan-based contract and trade on the Shanghai International Energy Exchange (INE), to start off successfully with a lot of enthusiasm and no glitches. Critics have said the contract will stumble because it will be denominated in yuan while the rest of the global oil market trades in dollars. Moreover, the INE will find it difficult to pull physical traders and financial speculators from the NYMEX WTI and ICE Brent markets, since they already have deep liquidity.

In other words, to silence critics, China needs its benchmark to “hit the ground running” from day one.

Trading volumes plunge

The sharp sell-off in Asian equities at the beginning of the year caught Chinese authorities off-guard.

The INE, a wholly owned subsidiary of the Shanghai Futures Exchange (SFE), was set to launch China’s crude benchmark at the end of last year, but bureaucratic squabbles and the dearth of enough brokers led to target dates being missed. The first quarter of this year proved even more difficult, with trading activity in many Asian markets drying up. The sharp sell-off in Asian equities at the beginning of the year caught Chinese authorities off-guard. The Shanghai Composite Index is down by a massive 40 percent since the middle of last summer, and volumes are 15 percent lower year-to-date and off by more than 21 percent versus year-ago levels. Some other commodities have taken big hits, too. China is the biggest consumer of copper, and prices collapsed during January, mirroring the fall in oil and equities. On the SFE, copper volumes in the first quarter fell by 18 percent versus Q4, though some of the decline occurred because of lower activity due to Chinese New Year.

At the same time, China’s currency has shown weakness. After a fierce rally during the second half of 2015, due in large part to central bank intervention in August, and the first couple of weeks of January, the yuan has lost about 2 percent versus the U.S. dollar. In mid-March, the yuan fell to a 15-month low versus a basket of currencies.

The volatile trading environment reflects an uncertain time for the exchange business, the country’s financial services industry, and the overall direction for the economy, making now not an ideal time to kick off a new major futures contract.

Contract specifications

There are also complications over the specifications for the crude contract, which has to be backed by physical supply. The contract is expected to reflect the price of medium, heavy sour crude, with five to seven grades included. But there’s a dispute over which grades to include to accommodate refiners and whether the contract will rely too heavily on crudes from the Middle East. The country’s independent refineries, which are called teapots, are at the center of the disagreement.

Last year, the Chinese government set up guidelines for teapots to start importing crude. Giving the green light to imports was to bolster the number of buyers in the country as it rivals the U.S. as the world’s top importer, and deepen trading activity ahead of the launch of the futures exchange. But many of the teapots can run only one grade, so the contract has to include a broad range of crudes in order to be satisfactory to the entire group. Teapots, one source said, have indeed begun importing crude in 2016, mostly from Middle East producers and commodity merchants. The teapots will be key for the success of the new crude benchmark: Using the new contract would provide initial liquidity and likely boost confidence to bring in other participants.

Despite setbacks, new benchmark will succeed

China is determined to liberalize its currency, build its political clout on the international stage, and become a dominant player in the global oil market. Establishing a successful crude benchmark helps achieve all three of these goals. That is why the Asian juggernaut, despite its economic anxiety at the moment, will continue moving forward in establishing the new contract, although the move will continue slower than planned.

China is determined to liberalize its currency, build its political clout on the international stage, and become a dominant player in the global oil market. Establishing a successful crude benchmark helps achieve all three of these goals.

Moreover, given that the non-OECD Asian market is the key engine of global oil demand growth and China is importing at high levels, around 8 million barrels per day in February, almost double domestic production, it is logical that the region has a liquid benchmark. The country’s refined product demand is forecast to average around 11.55 mbd in 2016, according to the International Energy Agency (IEA), up .33 mbd year-on-year. It is expected to continue to rise beyond this year even as it moves from an export-oriented economy to one led by consumer demand. Besides feeding its domestic fuel demand, China is building new capacity for its Strategic Petroleum Reserve (SPR), which should keep crude imports elevated for the time being. This year alone, some 100 million barrels of new SPR capacity should come online. Filling these tanks in 2016 would imply crude demand of .27 mbd, according to Barclays.

The benchmark is also critical for Middle East producers, as China is a key buyer for them. For Chinese traders, using a benchmark that reflects regional dynamics provides a much better option than trading WTI or Brent, both of which do not reflect Asian fundamentals. Currently, assessments for Dubai and Oman crudes by price reporting agency Platts are the closest thing to an Asian benchmark, and Chinese oil companies’ active role in these markets show the importance of a new futures contract. Furthermore, speculators and physical traders have an appetite for exposure to both the Chinese crude market and the country’s currency.

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Given that so much is hinging on the new benchmark, it’s no wonder Chinese authorities want to make sure they get it right before the contract is launched. Once it finally is given a green light, the benchmark will become an important price reference for international oil markets.

 

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