The Fuse

China’s Crude Benchmark Key in Developing the Yuan’s Power

by Matt Piotrowski | October 23, 2017

China is seeing its clout grow in the global economy and the international oil market. In the past two years, its currency, the yuan, was included as a reserve currency by the International Monetary Fund (IMF) and the country has surpassed the U.S. as the leading importer of crude oil. And now there are news reports that the Chinese are urging the Saudis to do oil deals in yuan and that China’s major oil companies may buy a private stake in Aramco. Such developments, should they occur, would bring large consequences for the oil market, the global economy, and the geopolitical balance of power.

The petrodollar system isn’t going to be turned upside down overnight, but China’s rising status will continue to disrupt the status quo, sending a powerful message that the country seeks to consolidate its strength as an economic superpower. “China is still in an important period of strategic opportunity for development,” President Xi Jinping said Wednesday. “The prospects are very bright, but the challenges are very severe.”

In order for China to achieve its goal of a more prominent currency, it needs to launch its crude futures exchange and establish a liquid Asian benchmark where deals will be denominated in yuan.

In order for China to achieve its goal of a more prominent currency, it needs to launch its crude futures exchange and establish a liquid Asian benchmark where deals will be denominated in yuan. If this program becomes a success and brings in outside players, China’s influence on the global oil market will grow and its ambitions of challenging the dollar’s supremacy could eventually be realized.

The CEO of independent trader Trafigura, Jeremy Weir, said last week at the Oil & Money Conference in London that the new contract will be launched after the People’s Congress, which is taking place this week. A report by the Nikkei Asian Review said the launch is “expected shortly.” So far, debuting the benchmark has been a drawn out process. The crude futures contract, to be run by Shanghai International Energy Exchange (INE), was originally scheduled to be up and running in late 2015. But it has been continually delayed because of bureaucratic fighting and questions over what specifics crude to use for delivery. Crude futures trading in New York and London is well established (NYMEX began in 1983) and the global oil market has no reason at this point to move away from the dollar.

China’s goal is to convince energy producers to settle deals in yuan and re-invest the money in the Chinese economy and include the yuan in their foreign currency reserves.

Nevertheless, that won’t keep China from furthering its ambitions in this area. China’s goal is to convince energy producers to settle deals in yuan and re-invest the money in the Chinese economy and include the yuan in their foreign currency reserves. The foreign exchange market contracted at the end of 2016, and claims in yuan made up less than one percent of the approximately $11 trillion market, according to the IMF. Investors are hesitant to leave the U.S. dollar because of its deep liquidity and its reputation as a safe haven. In the short to immediate term, even if oil producers were to settle in yuan, they would likely leave only a small percentage invested in the yuan, converting the rest to euro or dollar.

China needs liquidity, participation from major oil producers

It would take a major producer like Saudi to start selling in yuan and participate in the new benchmark for China’s ambitions to be realized. Hence, reports that China is trying to convince Saudi Arabia to trade oil in yuan should not come as a surprise. Russia is another key player. Russia is the largest supplier to China and perhaps the most likely to go the petroyuan route. Since Saudi Arabia’s market share to China has contracted, it might feel pressure to move to sales in yuan in order to tighten ties with Beijing.

China wants to make a political and economic statement with the new crude contract. It serves as part of a broader strategy to lure investors, traders, and producers to the Chinese market, and rival Western dominance.

For the benchmark to be successful, it needs both physical and non-commercial traders as contributors. The assessment for Dubai crude by price reporting agency Platts is currently the de facto Asian benchmark, and it has been dominated by trading units of Chinese companies Sinopec and PetroChina. But before outside players such as the merchants or speculators trade on the exchange, there needs to be sufficient liquidity. Foreign investors will likely be skeptical of trading oil in a non-dollar currency and the enormous presence of state players. As such, China will have to bolster the benchmark domestically before foreign players find it attractive. Trading sources tell The Fuse that the Chinese benchmark will be a local market (again dominated by the big Chinese companies) at first in order to provide risk management for the “teapot” refineries. More importantly, China wants to make a political and economic statement with the new contract. It serves as part of a broader strategy to lure investors, traders, and producers to the Chinese market, and rival Western dominance.

“They need participation, it’s as simple as that,” said one source. “The growth will be really, really slow.”

One former trader argues that the Chinese can find success in attracting outside participants if they establish the right set of regulations. “China’s traders and businesses will provide volume and liquidity to this exchange,” he said. “But if it is regulated correctly, i.e. structured like NYMEX contracts, with margin calls, etc., there would be no reason why foreign companies would not use the market, especially if they want exposure to the yuan.”

China plays the long game

Just because it will take years or decades for the yuan to become dominant in the global economy and international oil market, that doesn’t mean we won’t see implications of China’s rise before then. The petrodollar system was established in the mid-1970s when U.S. President Richard Nixon asked Saudi Arabia to trade oil in only dollars. Riyadh agreed, and other OPEC members agreed to do the same. As demand for oil rose, so did the demand for the dollar, further strengthening the U.S.’ power in the global economy.

Now that demand growth is overwhelmingly taking place in emerging markets, with China at the core, the global oil market isn’t as U.S.-centric. This shift gives the Chinese an opening to build its dominance. Even though China makes up approximately 13 percent of total oil demand compared to the U.S.’ 20 percent, Beijing wants to exploit the fact that its share is rising.

Big Chinese oil companies, besides inking major deals overseas, have dominated the Dubai benchmark, and the teapot refineries have become larger market players during the price downturn, sharply increasing their imports. China is even seeing its oil trading houses grow in size. CEFC China Energy recently made a $9.1 billion investment in Russia’s Rosneft, “giving it the sort of market clout to potentially challenge dominant Western oil traders like Vitol,” said Reuters. China’s crude benchmark is the next logical development in the country’s rise. Indeed, on October 7th the Shanghai Municipal Government published an action plan that urges the “prompt launch of the crude benchmark to promote spot trading and futures trading … to enhance international influence” and to more broadly to establish Shanghai as the head of the extensive “one belt one road” initiative. Becoming an energy hub, investing yuan in other countries, and getting the Saudis to pay with yuan are all pieces of a grand international strategy.

Becoming an energy hub, investing yuan in other countries, and getting the Saudis to pay with yuan are all pieces of a grand international strategy.

For the U.S., China’s increased power is a mixed bag and the full ramifications won’t be known for quite some time. The yuan’s rise will chip away at the dollar’s dominance, undermining the U.S.’ longstanding monetary advantage. At the same time, China’s influence on oil-producing nations will likely increase, negatively impacting the U.S.’ ability to sway those countries. But there is a positive side for the U.S. Should U.S. oil consumption decline and domestic production rise, the U.S. will ironically gain more flexibility in its foreign policy, even with oil producers. The U.S. can reduce its vulnerability to other countries that use oil sales as leverage to weaken the U.S.’ position and global power.

China’s development of its crude benchmark, along with bolstering the yuan, is one part of a broad strategy to increase its power in the international oil market and global economy. Since it will take China years, perhaps decades, to be fully realized its ambitions, the country is playing the long game, and for now, that is working in its favor.

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