China's new crude oil futures contract enjoyed a successful first day of trading in Shanghai, most likely exceeding the wildest hopes of its backers, but much of the hard work of building a viable benchmark still has to be done.
The new contract, launched on Monday by the Shanghai International Energy Exchange (INE), attracted interest from Western oil traders as well as domestic investors.
Some 20 million barrels of oil changed hands on the first day, with the first deal going to global trader Glencore , and other participants included major merchants Trafigura, Freepoint Commodities and Mercuria.
At one stage the volume of trades being done on the INE exceeded those in global rivals Brent and West Texas Intermediate (WTI).
The evident enthusiasm for the new contract would have pleased the INE. It aims to establish a third global benchmark in China, the world's largest crude buyer with imports averaging just over 9 million barrels per day for the first two months of 2018.
On the surface, there is no reason why the INE contract shouldn't take its place alongside Brent and WTI.
It's a far more useful marker for China - and for the rest of fast-growing Asia as well - given the seven grades of crude accepted for delivery are heavier and more sour than the light grades that make up Brent and WTI.
This means the INE contract better reflects the type of crudes that are more typically consumed in China, and in other major regional importers such as India, Japan and South Korea.
It's precisely this advantage that will really need to be honed if the first day's success is to be carried forward.
In effect, the INE contract is a sort of Chinese mirror of the already well-established Dubai Mercantile Exchange (DME) Oman futures.
The DME contract has a similar gravity and sulphur content to the INE equivalent, providing an opportunity to use both as hedges for physical purchases as well as arbitrage plays.
This dynamic is likely what will attract and retain international market players to the INE, as it will allow them to profit from any opportunities between the prices for free-on-board cargoes offered by the DME futures, and delivered to China cargoes by the INE.
DIFFERENT EXPECTATIONS?
The difficulty for Western investors in the INE is the still-to-be-determined risk of interference by the authorities in Beijing. The latter have a track record of changing rules and regulations for commodity trading if the market isn't behaving in their desired fashion.
Currency risk is also on the agenda, given the INE is settled in yuan and the other major oil contracts are in U.S. dollars.
There are other challenges for the INE, with one being that the contract is only traded in Asian hours, closing at 1500 local time, or 0700 GMT.
This excludes London and New York traders from getting in on the action in their own time zones, a factor that may hamper liquidity.
There is also a risk of different expectations of the various participants, with foreign trading houses, banks and oil companies seeking hedging and arbitrage opportunities. Meanwhile the Chinese government and state-owned majors may be seeking market control and the ability to pay for crude in their own currency.
Another factor that still has to be worked out will be how much of the volume and open interest is held by professional players, either foreign or Chinese, and how much is down to day traders and other small-scale investors.
Several of China's vibrant commodity contracts are dominated by smaller players, which can exacerbate swings based on sentiment or momentum, without too much based on market fundamentals.
But none of these problems are insurmountable, and can be addressed as the contract build ups a history and a reputation.
The key will be to keep an eye on volumes and open interest as a measure of the INE's success.
By Clyde Russell