Can Chinese oil benchmark really rival Brent and WTI?

Shanghai crude oil futures launched on Monday with small and institutional investors fuelling much higher turnover than many expected for China’s new commodity benchmark aimed at dominating the Asian market.

In a sign the contract has lured overseas interest, global commodity trader Glencore and big merchants Trafigura and Freepoint Commodities were among the first to trade, although regulatory hurdles and unfamiliar rules may stymie broader take-up in the near term.

The launch of China’s yuandenominated oil futures – its first commodity derivative to be open to foreign investors – marked the culmination of a decade-long push by the Shanghai Futures Exchange (ShFE) to give the world’s largest energy consumer more power in pricing crude sold to Asia, according to Reuters.

Almost 15.4 million barrels of Shanghai’s most-active September contract changed hands in the two-and-a-half hour morning session. That initially eclipsed volumes traded in the Brent May contract, before Europe’s benchmark came alive that day.

How serious is China about setting up Shanghai crude oil futures as a challenger to Brent and West Texas Intermediate?

It’s certainly doing some things right, according to Bloomberg. A functioning commodity benchmark requires crucial infrastructure. First, it needs enough suppliers to ensure individual producers cannot have too much influence.

A spread of producers also creates stability, preventing situations like Brent suffered last year, where the failure of a single pipeline risked sending prices out of control.

Next, it needs a decent array of customers. A primary reason Brent dominates is that almost every barrel can be shipped from its fields in the North Sea to any port in the world. WTI’s delivery point in Cushing, Oklahoma, is hundreds of miles from the ocean, and the US in any case banned crude oil exports for 40 years until 2015.

Additionally, a well-honed market structure that allows producers, consumers and traders to hedge exposure through futures and options is needed. To be relevant to participants in many countries, it also needs currency hedging so that (for example) Japanese refiners do not get side-swiped by a sudden jump in the yen against the dollar.

One thing that is not required, strangely, is a grade of oil that relates closely to what consumers actually buy. Refiners in both China and the US Gulf Coast process mostly medium sour grades that are relatively dense and rich in sulphur compared with the sweet light crudes on which Brent and WTI are based.

That is repeatedly cited as a problem, but touted alternatives such as Loop Sour never seem to get off the ground – not a great omen for Shanghai crude, another medium sour contract.

Most market participants, it seems, would rather apply the standard sourness and gravity discounts to the most liquid benchmarks than try to set up a rival.

One positive for Shanghai crude is that the contract will be based on seven grades, mainly from the Arabian Gulf but also including China’s Shengli.

What was a surprise to many was that Glencore – not a Chinese state oil major – executed Shanghai’s first crude deal.

Swiss commodity trader Trafigura, Freepoint in the

US and independent refiner Shandong Wonfull were other early participants, Reuters said.

That went against the received wisdom that as a yuandenominated contract, it’s primarily going to be bought by China’s domestic duopoly of PetroChina and China Petroleum & Chemical with a smaller trickle heading to the handful of plants operated by Cnooc and Sinochem, plus the array of independent processors known as teapot refineries.

The early involvement of big international players was a morale boost to the fledgling market. The most-active September contract opened at 440.4 yuan ($69.78) per barrel versus a reference point of ¥416, jumping as high as ¥447.1 ($70.85) in the first few minutes.

Even if Chinese oil futures became the most liquid crude contracts in the world, they would be tied to the deeply illiquid offshore yuan.

The yuan was used in only 4 per cent or so of foreign-exchange transactions in 2016, making it a less useful currency than the Australian or Canadian dollars or the Swiss franc.

As has been argued before, there’s a chicken and egg issue here. Yuan-denominated oil is seen as a crucial part of internationalising the yuan as a global currency, but that goal can never really be attained while Beijing insists on maintaining current levels of control over its capital account.

Until that changes, Brent and WTI will continue to rule this roost.