Asia Oil Trading at 'Inflection Point': Russell

Imagine what crude oil trading will look like in Asia in 10 years' time. Probably quite different to like it does now.

In recent months oil markets east of Suez have been roiled by the increasing influence of the trading arms of China's state-controlled giants, PetroChina (PCCYF) and Sinopec .

PetroChina's Chinaoil has effectively boosted the price of the benchmark Dubai crude by bidding aggressively for cargoes in the price discovery mechanism run by Platts, known as the Market on Close (MoC) or colloquially as the "window".

This has increased the price of Dubai crude relative to other benchmarks such as Brent, as well as raising the ire of other market participants from producers to traders and refiners outside China.

So great is the consternation that the talk of last week's annual oil industry gathering in Singapore was how to either fix or dump the Platts system.

In some way the criticism of Platts is incorrectly aimed, and is somewhat akin to shouting at the referee because you no longer like how the opposition is playing the game.

The Platts MoC system is under pressure, but it's still delivering what it's supposed to, namely a price benchmark and discovery process.

But what the market has discovered is that the rise of China to be the world's largest importer of crude and fuels on a net basis means that Chinese traders can exert considerable influence, and are no longer wary of doing so.

How might things change with the next decade, firstly to reflect the new reality of China being the most important crude buyer in the world, and secondly to allow a transparent market that has the confidence of all participants?

The big assumption to make is that the new, Chinese futures contract not only launches successfully, but gains enough traction to become the regional benchmark.

The Shanghai International Energy Exchange, known as INE, may start trading futures in October, settled in yuan and deliverable to Shanghai and other northeast China locations.

The deliverable crude grades are said to include Oman, Dubai and grades from Abu Dhabi, with the possibility of similar, heavy and sour, crudes being included as well.

Oman is the main grade currently available through the Platts MoC process, as well as the futures traded on the Dubai Mercantile Exchange (DME).

The problem for the new Shanghai contracts is likely to be the same as for the current MoC and DME mechanisms, namely a limited supply of freely traded cargoes.

However, this isn't necessarily a deal-breaker as Brent, the global benchmark, is unwritten by even fewer cargoes than Oman.

What is more key is market acceptance of the benchmark and confidence in its transparency.

Being traded in yuan may also present an obstacle for the INE, as it will force international players to take on and manage currency risk, something they may well be reluctant to do.

ANY PARTNERS FOR SHANGHAI?
This means that for the INE to be truly successful, it will likely have to partner, formally or informally, with an exchange outside of China.

The logical choice would be the Singapore Exchange (S68.SI) (SGX), given it already has a major presence in commodities destined for China, such as iron ore and coal, and is located in a hub that's already home to the bulk of the region's oil traders.

If the SGX, or another credible provider, could offer a U.S. dollar traded and settled mirror contract to the INE's yuan oil contract, it may boost liquidity and bring credibility to the Shanghai futures.

It's hard to see how a yuan-only contract will be able to become the region's benchmark, even if it does attract the support of producers, traders and refiners.

But the fact remains that a China-focused contract should emerge and become the globe's third major crude benchmark after Brent and West Texas Intermediate (WTI).

This would allow arbitrage and hedging across the world, and make sure that each of the world's top consuming regions, namely North America, Europe and Asia, had a suitable price benchmark.

If the INE does rise to prominence, will that necessarily mean the death of contract like the DME's Oman or the Platts MoC process?

No, but it does mean they will have to adapt and fight to make sure they have a place in the market.

The existence of Brent futures and a Platts Brent benchmark for physical oil show that the emergence of Shanghai shouldn't spell the end of the MoC process.

However, to remain relevant in Asia, Platts will have to ensure that the market regains confidence in the process, and that means taking on the ability of Chinese traders to dominate the process seemingly at their leisure.

Whether this means adding in more crude streams or tightening rules, Platts is unlikely to sit back and watch competitors take a market that it worked so hard to build up.

Likewise, the DME may benefit from being able to encourage investors to play arbitrage between its contract, which is effectively a free-on-board Middle East loading contract on Oman crude, and the INE's new futures, which will be a delivered China contract, again mainly on Oman.

This sort of arbitrage may appeal to shippers, traders and refiners keen to exploit differences in freight and insurance rates, as well as those seeking to benefit from differences in timespreads.

One thing is certain, the rise of China, and to a lesser extent India, as the top crude consumers globally is going to change things, and it's likely that the inflection point has already been reached.

By Clyde Russell