China's Crude Oil Futures Dilemma - Control or Success?

 

It has been a long-standing ambition for a new global oil price benchmark to be established in Shanghai, a move that would reflect China's rise to vie with the United States as the world's largest importer of the fuel.

 

But it would seem that the plans are on hold, at least for now, with the Shanghai International Energy Exchange (INE) failing to garner sufficient support from market players for a new benchmark, Reuters reported on Jan. 20, citing five sources with knowledge of the matter.

 

The main issues were concerns by international players about trading in yuan, given issues surrounding convertibility back to dollars, and also the risks associated with regulation in China.

 

The authorities in Beijing have established a track record of clamping down on commodity trading when they feel the market pricing is driven by speculation and has become divorced from supply and demand fundamentals.

 

On several occasions last year, the authorities took steps to crack down on trading in then hot commodities such as iron ore, steel and coal.

 

While these measures did have some success in cooling markets, they are generally anathema to international traders, who prefer to accept the risk of rapid reversals in order to enjoy the benefits of strong rallies.

 

It's likely that while the INE could design a crude futures contract that would on paper tick all the right boxes, it would battle to overcome the trust deficit that exists between the global financial community and China.

 

What international banks and trading houses will want to see before they throw their weight behind a new futures contract is evidence that Beijing won't interfere in the market to achieve outcomes in line with its policy goals.

 

It will be hard, but not impossible, to guarantee this, with the most plausible solution being the establishment of some sort of free trade zone in which the futures contract could be legally housed.

 

But getting everybody to agree on the exact mechanisms of how this would work will be extremely challenging, and time consuming.

 

Overall, what this means is that Asia, the world's top crude-importing region, will have to soldier on with its current imperfect ways of pricing crude oil.

 

ASIA STILL WAITING

 

The global benchmark futures contract on Brent crude, operated by Intercontinental Exchange (ICE) and CME Group (CME)'s New York Mercantile Exchange, don't really reflect the reality of crude trading in Asia.

 

The most obvious problem is that Brent is a light crude oil, while most of Asia's physical trade is in heavier grade crudes, such as those pumped by Middle East producers.

 

The Dubai Mercantile Exchange (DME) operates a well-respected contract on Oman crude, but despite offering a viable hedging tool and physical trading platform, the contract has struggled to become a leading benchmark.

 

For example, the daily volume of contracts on the DME averaged 8,762 lots in 2016, while Brent futures on ICE averaged about 57,600 last year.

 

For many oil traders in Asia the main price discovery mechanism is the Platts trading window, known as the Market on Close.

 

This system allows traders to buy and sell various grades of Middle East crudes through the Platts system.

 

While the various participants can see buyers and sellers, the data isn't available to the wider market, meaning it lacks the transparency of a deliverable futures contract and is of little use to non-physical crude traders.

 

The Platts window is also vulnerable to undue influence by major traders, given the limited number of cargoes each month and the ability of some major players to buy most of what is available.

 

While Platts has worked to address the issues by adding more grades of crude, the current system is probably a long way short of ideal, and doesn't reflect the importance of Asia in global crude markets.

 

There is little doubt that the current ways of pricing crude belong to an era where the United States and Europe were the predominant buyers, and physical traders were a cosy circle of insiders who preferred to operate largely without regulation and scrutiny.

 

It's natural that China wants to flex its muscles in global commodity trade, and it also makes sense for Asia to have a crude oil benchmark directly related to the types of crude it consumes.

 

It's also logical that this contract should be based in China, but in order to achieve success it will have to enjoy the confidence of all participants.

 

It will have to be liquid, convertible and stable from a regulation viewpoint.