There’s an Oil Shortage Coming…and China Knows It
Six weeks ago, China launched yuan oil futures contracts for the world to trade.
It was the key topic, dominating financial market new sites at the time.
Then the Korean leaders met. Suddenly, oil markets weren’t as important anymore.
Don’t get me wrong, the gentleman’s denuclearisation agreement between North and South Korea is a big deal.
But we’ve seen these handshakes before.
How long it lasts remains to be seen. As Jim Rickards explained in a private email overnight, the only thing that’s changed here is the timeframe of North Korea’s plans.
The way Jim sees it, Kim Jong-Un will tell the political class what they want to hear, and then the dictator will go about his business, regardless of the promises he’s made. The North Korean ruler is merely delaying his plans.
Meanwhile, as the media spent most of April political-people watching, the commodity markets were a second thought. But they shouldn’t be…
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China has big plans for commodities trading. And yuan oil futures are just the beginning.
Since the yuan oil futures began trading, the price of WTI and Brent crude has risen 10% and 11% respectively.
Yet, there’s almost no analysis of the yuan oil futures since their launch.
Which is odd, given that the yuan oil contracts were called a new ‘benchmark’, and that China was going to ‘shake up’ the oil trading industry.
However, China allowing outsiders to trade yuan oil futures is a very important step, one which has nothing to do with creating an international benchmark.
Well, let’s have a look at how the yuan oil futures trading measures up to the international benchmarks…
Trading volume for crude oil contracts for September 2018 delivery
It goes without saying that the WTI crude (blue column) and the Brent crude (brown column) are the most popular global oil futures to trade. Although the rising Shanghai oil contracts (red column) for September 2018 delivery appear to be a genuine threat to the current WTI and Brent benchmarks.
On paper the yuan oil futures look to be increasing in popularity. That’s not the case.
In order for the yuan oil futures to take off, the entire oil supply chain needs to join in. It’s not so much commodity brokers that matter, but oil companies looking to hedge the price of their own product need to want to trade them.
Considering most oil companies trade in US dollars, it makes sense to trade oil contracts denominated in US dollars. There’s little incentive for oil producers to expose themselves to currency risk, by trading in yuan.
Furthermore, the yuan oil futures are based on an uncommon type of crude.
The light, sweet crude oils are the ones in high demand around the globe. The WTI is a high quality, light sweet crude favoured by the US. Whereas the Brent crude is another light, sweet crude in high demand in the Euro zone.
That’s in contrast to the yuan oil futures contract, which is based on a sour, heavy crude, mostly in demand by Middle Eastern countries.
Not only that, but early analysis of the Chinese yuan oil futures suggests the ‘demand’ for these contracts is predominantly local traders and companies. Ones that are being heavily pressured by Chinese authorities to trade these to make the contracts appear more liquid than they really are.
In other words, it’s local Chinese trading companies buying and selling yuan oil futures, hoping international market will be drawn into the trading pool.
Forcing yuan on the world
It’s understandable why China would create this demand. Authorities can’t have egg on their face. They’ve created these yuan oil futures, and they need us to believe there is a market for yuan oil contracts.
China is the largest importer of oil in the world. And the third largest consumer of the stuff. So local oil contracts is less about setting an international oil bench mark, and more about becoming a ‘price maker’ then a ‘price taker’.
That is, the middle kingdom wants to set the price for the oil it so desperately needs.
Now that may happen one day. A decade or so from now, the sour heavy crude contract China offers may be the type of oil in demand.
But the yuan oil futures was never about creating an international benchmark.
Instead, it was about spreading the yuan throughout the financial system.
No one wants yuan, except the Chinese. As March this year, only 16% of Chinese trade is settled in yuan inside China. Global share of yuan payments for trade sits at 1.78%. Which is way behind the dominance of the US dollar, euro, pound, yen and even the Canadian dollar.
The yuan oil futures contracts, is more about challenging the US dollar that dominates the international payments system.
Spreading the yuan into the financial system is one step towards building credibility for the currency.
For now, there remains broad trust, however flagging, in the US dollar, and little in the yuan.
Pushing more yuan into the financial system may encourage more people to accept it.
Editor, The Daily Reckoning Australia