22 January 2018

China’s Bid to Upend the Global Oil Market

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Sometime soon, after the close of the Chinese New Year, officials in Shanghai will flip the switch and start trading in an arcane new financial product — one that could presage a huge shift in global energy markets and advance China’s quest to play a bigger role in the global economy. After years of false starts, a long-awaited Chinese oil futures contract will make its debut on the Shanghai Futures Exchange, likely in late March. It will be the first crude oil benchmark in Asia, which is important because that’s where oil consumption is growing the most. And it will be the first contract priced in Chinese currency, known as the renminbi or yuan. Currently, the main global benchmarks for crude oil are in New York and London — and priced in dollars.

If the new contract gains traction among international oil companies and traders — still a big if, given Beijing’s habit of meddling with financial markets and its currency — it could go a long way toward righting the energy market. In recent years, a seismic shift has taken place as China has dethroned the United States as the world’s biggest oil importer, yet that’s not really reflected in the commodities market.

“For the oil market, it shows how the center of gravity is shifting to Asia. It means the U.S. is not front and center in the oil market anymore,” said Matt Piotrowski of Securing America’s Future Energy, a nonprofit focused on U.S. energy security.

The contract, dubbed the “petroyuan,” is one small part of China’s yearslong on-again, off-again bid to make its currency a bigger player on the global stage.
The contract, dubbed the “petroyuan,” is one small part of China’s yearslong on-again, off-again bid to make its currency a bigger player on the global stage.

Even though China’s economy has grown tenfold this century to become the world’s second largest, the global financial system is still dominated by the dollar, the euro, and the yen, reflecting Beijing’s previous bit-player status. China’s ultimate goal is to translate its growing economic might into levers of real influence that come with having a globally used currency like the dollar today or the pound sterling in decades past.

That push seemed to be making great strides, with a growing share of cross-border trade settled in renminbi rather than yen or dollars, and with the yuan making inroads into overseas capital markets, including London. A symbolic boost came in late 2015, when the International Monetary Fund agreed to include the yuan in its basket of global currencies, a sign it was shedding its poor-cousin status.

But then progress stalled. The yuan plunged in value, even as Beijing redoubled efforts to prop up the currency, interfering to tamp down volatile financial markets and regulating the flow of capital. That dampened the international appeal of holding the yuan and seemed to mark an inflection point in Beijing’s quest to internationalize the currency, said Barry Eichengreen of the University of California, Berkeley, who has written extensively on the topic.

“In fact, the Chinese have been moving in the opposite direction since the financial volatility of 2015, and as a result the yuan has been losing ground as a currency in which to invoice trade, settle cross-border transactions in general, and hold reserves,” he said.

Lately, though, there have been indications that the yuan is starting to claw back some ground.
Lately, though, there have been indications that the yuan is starting to claw back some ground. The government has slightly loosened its micromanagement of the exchange rate, and the currency hit a two-year high against the dollar this week.

The yuan seems to be regaining prominence in cross-border trade after falling out of favor for a couple of years. And new regulations are meant to spur that trade even further, by making it easier for Chinese and international companies to do business in yuan. Pakistan, a big economic partner of China, is toying with conducting all bilateral trade in yuan rather than in dollars. China is even using yuan rather than dollars to buy physical cargoes of oil from countries like Russia — and hopes to do the same with its other major supplier, Saudi Arabia.

And banks are also snapping up yuan for their currency reserves, a sign of the renminbi’s slowly growing acceptance as an international currency: Banks’ holdings of the yuan passed the $100 billion mark late last year, though it remains far behind global stalwarts like the dollar, euro, yen, and pound. The European Central Bank, which had already set up a currency swap line with the People’s Bank of China to grease two-way trade, just revealed that it dumped 500 million euro worth of greenbacks to add yuan to its reserves last fall; the Deutsche Bundesbank followed suit earlier this month.

Now comes the oil futures contract, a milestone that’s been in the works for years but that was repeatedly delayed by volatile markets and concerns about Chinese state interference in capital markets.

The contract will feature the kind of oil that makes up a big share of Chinese consumption — typical Middle Eastern grades known as “medium sour” — rather than the U.S. or British crude that has dominated global pricing for decades. That’s important because it could help bring the world’s biggest commodity market more in line with the changing physical realities on the ground.

“It makes increasing sense to have an Asian benchmark given where demand growth is going to be found in coming years,” said Ole Hansen, head of commodity strategy at Denmark’s Saxo Bank, who has been following the launch of the petroyuan closely. In the last couple of years, China has passed the United States as an oil importer, buying up to around 8 million barrels a day.

In years to come, if the contract is a success, millions of barrels a day of oil could be priced in yuan rather than in dollars, Hansen said, “which would further increase China’s importance on the global stage, while further eroding the importance of the dollar.”

It’s not at all clear the oil contract will make quite that big a splash. Commodities experts, including Hansen, expect a slow takeoff as oil companies and traders wait to see if the contract attracts enough participants to provide the kind of market liquidity that makes for a global benchmark.

Initially, said Piotrowski of SAFE, it might be most attractive to small, independent Chinese refiners — known as “teapots” — who could hedge their financial risk of buying oil by doing business in their own currency rather than in dollars.

What’s more, China’s meddling with the currency and capital markets could spook some international financial players used to the wide-open markets in New York and London.

The yuan contract is “small potatoes, mainly of symbolic value,” Eichengreen said.
The yuan contract is “small potatoes, mainly of symbolic value,” Eichengreen said. He added that the seeming shift away from the dollar’s stranglehold on the oil market is less revolutionary and more a return to how things used to be.

“We’ve seen a world before where several national currencies are used in oil market transactions,” he said, noting that decades ago the dollar and pound were both widely used.

Ultimately, though, if China hopes to throw its weight around in the energy market and make the petroyuan a big success, Beijing will have to make the kind of far-reaching reforms it has so far resisted making in order for the yuan to become a global currency. That includes allowing the currency to float freely and removing limits on capital flows — still risky moves for a government that micromanages economic policy.

“China would have to substantially eliminate restrictions on international financial transactions in order for the renminbi to become a leading reserve currency,” Eichengreen said. Instead, “it continues to tighten restrictions.”

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