The Fuse

China’s New Crude Benchmark Will Flourish, Undermining Brent and WTI

by Matt Piotrowski | September 21, 2015

China is poised to establish the world’s third crude futures benchmark, a logical step given the country’s growing importance in the oil markets and its determination to flex its economic muscle on a global scale. The futures market, to be launched by the Shanghai International Energy Exchange (INE) in first half of 2016, will rival the InterContinental Exchange’s (ICE) Brent contract and CME’s NYMEX West Texas Intermediate (WTI).

The new Chinese contract will be denominated in yuan, part of an effort to strengthen it as a global currency and challenge the U.S. dollar’s supremacy.

The new Chinese contract will be denominated in yuan, part of an effort to strengthen it as a global currency and challenge the U.S. dollar’s supremacy. This provides a host of opportunities and risks. The benchmark will prove a net positive for the oil trading world, but its success will take time to develop: China needs to attract a wide variety of investors who may be skeptical of oil being traded in a non-dollar currency and the market power of state players.

The move is the latest example of Chinese financial institutions further expanding into the global economy as the government attempts to open its markets to outside players.

“The single largest strategic motivation of the new crude benchmark is to develop more pricing power in commodities,” said Jennifer Harris, a fellow at the Council on Foreign Relations (CFR) and previous member of the policy planning staff at the U.S. Department of State responsible for global markets and energy security.

One positive for the new crude futures benchmark, which will be a sour crude contract with each lot equivalent to 100 barrels of oil, is that it will be run by INE, a wholly owned subsidiary of Shanghai Futures Exchange (SFE). SFE is a well-established exchange, so it provides connectivity and transparency, giving it a good chance the benchmark will indeed bring about the needed liquidity over the longer term. This will be the first instrument in the commodities space where non-Chinese players have access to Chinese liquidity, which makes it attractive to investors outside of the country who have sought more access to the Asian juggernaut.

A logical benchmark

In a reflection of how important China is to the global oil market, it is the largest oil importer (though its place at the top goes back and forth with the U.S.) and has underpinned demand growth for the last decade or so. In 1995, roughly 75 percent of Middle East oil went to the Atlantic basin, but now about 75 percent heads to the Asia-Pacific region. With this major shift, it is only natural that a crude oil benchmark is established in Asia and reflects the dynamics of the region.

China’s demand now averages around 11 million barrels per day, roughly 12 percent of the world’s total, and is expected to reach 13 mbd by the beginning of next decade, even with demand growth at a modest 3-4 percent per year. Even though the economy has taken big hits lately, demand growth is underpinned by new vehicle sales, a growing middle class, and strategic and commercial crude stockpiling.

The benchmark will be critical to Middle East producers, as China is a key outlet for them and they are offering discounts to Asian buyers to build long-term relationships. Last year, Middle East crude made up more than 50 percent of the country’s imports. Saudi Arabia is the top supplier from the region, while Oman is another key exporter to China. With Iraq and Iran both increasing output, they will want to further penetrate the Chinese market.

The benchmark will be critical to Middle East producers, as China is a key outlet for them and they are offering discounts to Asian buyers to build long-term relationships.

For Chinese traders, by using a benchmark that reflects regional dynamics, they are provided a much better option than trading WTI or Brent, both of which do not mirror Asian fundamentals. Currently, the assessment for Dubai crude by price reporting agency Platts is the closest thing to an Asian benchmark, and it has been dominated by trading units of Chinese companies Sinopec and PetroChina. Their activity will simply shift to the Chinese futures contract. The advantage for the benchmark is that it is specific to China itself and allows for paper trading (buying and selling futures or options without the intention of taking delivery), providing opportunities for investor speculation, a key in fostering deeper liquidity that benefits commercial players who want to hedge forward to reduce risk.

The benchmark will be relevant beyond Middle East players. Russia is pivoting to Asia to diversify their customer base away from Europe, while OPEC member Angola is another big supplier. Latin American producers, notably Venezuela, have also made inroads in the Chinese market.

Challenges, and opportunities

While the benchmark appears poised to take off, there are some major obstacles, not least of all the contract being traded in yuan. This move is a clear challenge to the dollar’s dominance as the world’s top reserve currency.

“China is making good on plans for currency reforms and has put all the pieces in place for this benchmark to be denominated in yuan,” said CFR’s Harris. “It obviously would be easier to do in dollars, but this move offers some lens into unspoken motivations.”

Investors will need to have confidence in the currency and financial markets in China in general. There may be hesitation among potential players because of recent government intervention to prop up the economy by buying shares and limiting short-selling.

The issue of the yuan may not be as big an obstacle as it appears, however. Some potential participants may obviously balk, but with algorithmic trading dominating financial markets, players can easily run converters to show the dollar equivalent. For Gulf oil producers, they may in fact prefer to diversify away from trading in the dollar.

“Gulf countries have been hurt by fluctuations in the dollar and now they have an alternative and it’s with their largest customer.”

“Gulf countries have been hurt by fluctuations in the dollar and now they have an alternative and it’s with their largest customer,” said Harris.

Another major concern for potential investors, which may slow down the development of the benchmark, is the power of state-owned companies on the exchange. Players may see the dominance of Chinese actors in the Dubai market as a harbinger of what may occur with the new benchmark.

Broken Atlantic basin benchmarks

Of the two Atlantic basin benchmarks, Brent appears to be more threatened by an Asian benchmark. Futures trading volume on the NYMEX and ICE fluctuate on a daily basis, and have been very high lately, reaching 1 million lots at times. Two-thirds of the world’s crude is priced off of Brent, and WTI is the price marker for the United States, which remains the world’s largest consumer by a dramatic margin.

With Brent, crude oil that flows to Asia is currently priced off Brent, making it vulnerable to volumes and open interest shifting to the Chinese market.

With Brent, however, crude oil that flows to Asia is currently priced off the European marker, making it vulnerable to volumes and open interest shifting to the Chinese market. Moreover, China’s new contract will be for sour crude, and more than 60 percent of the world’s production is sour; thus, it could be seen as more reflective of global prices. By contrast, Brent and WTI are light, sweet grades that trade at premiums to the more widely refined sour crude. They both have other structural issues—North Sea output is in decline, while WTI is land-locked and U.S. producers can’t freely export.

A big positive for oil traders and analysts is that transparent pricing in China rounds out the global outlook, with the key consuming region now to be reflected in a benchmark that the market has crucially needed.