Reasons to Turn Sour on China's New Oil Futures

(Bloomberg Gadfly) -- How serious is China about setting up its new Shanghai crude oil futures as a challenger to Brent and West Texas Intermediate?

It's certainly doing some things right. A functioning commodity benchmark requires crucial infrastructure. First, you need enough suppliers to ensure individual producers can't have too much influence. A spread of producers also creates stability, preventing situations like Brent saw last year, where the failure of a single pipeline risks sending prices spiraling out of control.

Next, you need a decent array of customers. A primary reason Brent dominates, being used to price about two-thirds of the world's oil, 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 U.S. in any case banned crude oil exports for 40 years until 2015.

Away from the physical side of things, you need a well-honed market structure that allows producers, consumers and traders to hedge exposure via futures and options. To be relevant to participants in multiple countries, you also need currency hedging so that (for example) Japanese refiners don't get side-swiped by a sudden jump in the yen against the dollar.

One thing you don't seem to need, strangely, is a grade of oil that relates closely to the stuff consumers actually buy. Refiners in both China and the U.S. Gulf Coast process mostly medium sour grades that are relatively dense and rich in sulfur compared with the sweet light crudes on which Brent and WTI are based.

Reasons to Turn Sour on China's New Oil Futures

That's continually 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.

What does all that mean for Shanghai crude? One positive is that the contract will be based on seven different grades, mainly from the Persian Gulf but also including China's own Shengli.

That should ensure diversity of supply. On the demand side, things aren't so attractive. As a yuan-denominated contract, it's primarily going to be bought by China's domestic duopoly of PetroChina Co. and China Petroleum & Chemical Corp., or Sinopec, with a smaller trickle heading to the handful of plants operated by Cnooc Ltd. and Sinochem Group, plus the array of independent processors known as teapot refineries.

It's in market infrastructure that things really fall down. While Shanghai is offering 15 futures contracts with delivery dates stretching from September to March 2021, options trading -- a fundamental building block of most commodities markets -- is only in its infancy in China. It's barely a year since the first local commodity option, on soymeal, started trading on the Dalian exchange. That will make hedging far more difficult.

The more profound problem is currency. While Shanghai has gone to some lengths to open the market to international traders, very few of those players will want to find themselves at the mercy of a currency operating with a closed capital account.

Reasons to Turn Sour on China's New Oil Futures

Even if Chinese oil futures became the most liquid crude contracts in the world, they would be tied to the deeply illiquid offshore renminbi. The yuan was used in just 4 percent 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 Gadfly has argued before, there's a chicken and egg issue here. Yuan-denominated oil is seen as a crucial part of internationalizing the renminbi 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.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

David Fickling is a Bloomberg Gadfly columnist covering commodities, as well as industrial and consumer companies. He has been a reporter for Bloomberg News, Dow Jones, the Wall Street Journal, the Financial Times and the Guardian.

To contact the author of this story: David Fickling in Sydney at dfickling@bloomberg.net.

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