China's new crude futures contract faces a mountain of obstacles to overcome if it is to establish itself as a viable benchmark for trading with the world's largest oil importer.
The Shanghai International Energy Exchange (INE), which is part of the Shanghai Futures Exchange, said on Feb. 9 it would launch the much-delayed contract on March 26.
In theory, this will give China a powerful tool to shake up global crude trading by offering pricing and hedging in the heart of the world's biggest market for imported crude.
The reality is likely to be somewhat different, with potential market participants likely to be cautious until they see how the various dynamics play out.
Some of the issues that will need to be addressed are:
- How liquid will the contract be, given the limited number of potential buyers for physical delivery at the bonded storages in China?
- How much government intervention is likely, given Beijing's penchant for adjusting rules and regulations to influence pricing if the market moves in a direction deemed undesirable?
- Will foreign-based traders be happy to work in a yuan-denominated contract, with the associated currency risk and convertibility issues?
- Will trade in the new contract be dominated by the state-owned Chinese majors to the exclusion of opportunities for others?
- Given the contract is deliverable in China, how will the inclusion of freight costs affect trading?
But perhaps the biggest challenge face the INE contract is the fact that it is effectively based in a demand centre, rather than a production centre, as are the other major oil futures.
The three main existing benchmarks, Brent, West Texas Intermediate and the Dubai Mercantile Exchange's (DME) Oman, are based in production centres and the delivery points are close to where the oil is actually pumped.
It's actually difficult to find futures in the commodity world that are based in a demand centre, with most successful contracts being set up near points of supply, a system that has allowed producers, traders and consumers to hedge risks and discover prices.
The INE contract will be pioneering a different type of future, with the specifications showing that each contract will be for a volume of 1,000 barrels, and the deliverable crudes being a mix of tradable Middle Eastern medium-sour grades, as well as Shengli, a domestic crude.
The INE has approved six bonded storage sites at eight locations in China, with a total usable capacity of 19.8 million barrels.
NO GUARANTEE OF SUCCESS
It appears that the contract has been well-designed and there is little to fault from a technical perspective, but this alone is unlikely to be enough to guarantee success.
The 1,000-barrel per lot and the minimum transaction margin of 5 percent of contract value are probably large enough to deter day traders and small-scale speculators.
However, this is a double-edged sword as it will limit liquidity and volatility, two things that can be attractive to traders.
Some of China's most successful commodity futures contracts, such as iron ore on the Dalian Commodity Exchange, are dominated by day traders, with the volumes they bring helping establish the derivatives as important regional price indicators.
Overcoming the trust deficit between foreign market participants and the Chinese authorities also looms large, and it's likely that many potential players will be keen for the INE to establish a track record before they become involved.
Another risk for the new contract is that the Chinese authorities want it to succeed so much that they effectively force state-owned majors, and even smaller independent Chinese refiners, to use the INE.
This could well boost volumes and give the contract the semblance of success, but it would be artificial and thus probably not as effective as it could be as a hedging tool.
There is little doubt that China is seeking to play a bigger role in global crude trading, a reasonable ambition given it has overtaken the United States as the world's biggest buyer.
However, establishing a new price benchmark is extremely difficult, as the DME can tell you from their experience in trying to build the Oman futures as the main Middle East marker, despite it being a contract with arguably better technical specifications than both Brent and WTI.
The INE deserves a shot at success, and ultimately it makes far more sense to have a price benchmark for Asia based in the region's top consumer, rather than using contracts that reflect a few small fields in the North Sea or storage tanks in Oklahoma.
By Clyde Russell