Insight from Shanghai: China’s international crude contract marks first birthday

It’s now a year since China took the first steps to opening up its mainly domestic futures market to the world with the launch of the Shanghai crude oil futures contract.

It was the first of three to be “internationalized” last year – the other two were the existing iron ore and PTA futures contracts. But Shanghai crude was different to those in that it was a new contract, hosted on a new trading venue – the Shanghai International Energy Exchange (INE) – and designed specifically to attract international participants.

The goal was to create a new China-based global pricing point for crude alongside incumbent international crude futures contracts NYMEX WTI and ICE Brent.

The success of a new futures contract is typically measured by its liquidity, market depth and open interest. In the case of a physically settled contract, the delivery mechanism of any new contract will also be closely scrutinized by the market.

Liquidity & market depth

While liquidity is not everything when it comes to benchmarks, when it comes to derivatives it certainly helps. In February, less than a year after it started trading, 2,116 million barrels of Shanghai Crude were traded. It took ICE Brent more than 14 years to reach a similar monthly volume.

But the comparison has to be seen in historic context. When Brent was launched in 1988, electronic trading had yet to be invented and orders were taken by brokers in colorful jackets shouting at each other across the trading floor. It was only when ICE moved Brent over to fully electronic trading in 2005 that volumes really soared and it became the derivatives success it is today.

Liquidity on Shanghai crude is generally concentrated in just one contract. This is usually the contract that expires at the end of the current month. However, in the last 10 days before expiry liquidity moves to the next month forward as traders who are not allowed to take physical delivery are forced to liquidate their positions and roll them into the next contract.

On March 25, with just four days before the April 2019 contract expires, virtually all the volume and open interest had moved to the May 2019 contract, which expires at the end of April.

A medium sour contract

The price of Shanghai crude reflects the price of one of seven medium sour crudes – all but one of them from the Middle East - held in bonded tanks located on the coast of China. While one might expect the price to track Platts Dubai, the Middle East benchmark, the price of Shanghai crude actually more closely follows ICE Brent.

This is reflected in its trading patterns: Shanghai crude is most active during the night session after 9 pm Beijing time when European and US exchanges are active and it can be traded against other futures like ICE Brent and NYMEX WTI.

It is also worth noting that because the Shanghai contract is denominated in Chinese yuan not US dollars, the value of the contract is susceptible to changes in the yuan-dollar exchange rate; as the Chinese currency strengthened against the dollar in February, the price of Shanghai crude when converted into dollars fell by around $2/b against ICE Brent and Dubai.

Delivery

Seven monthly contracts have expired since the INE launched Shanghai crude, with six of these being settled by physical delivery. The first delivery in September last year saw 600,000 barrels change hands. The very low volume of crude in exchange-approved tanks in the month of the first contract expiry – at one point it fell to just 100,000 barrels – saw the price of the contract whipsaw compared to other crude benchmarks, in response to fears that there would not be enough oil in tank to meet delivery.

Since then the volume of crude on warrant and volume delivered has risen, averaging slightly over 2 million barrels over the last three deliveries. And prices have been less volatile versus international benchmarks over the last few deliveries.

While the intention of the INE is to internationalize the contract, a year after its start it remains primarily a domestic affair. INE data from mid-December shows that around 92% of the trading volume and around 80% of the open interest was accounted for by Chinese traders. Retail investors account for slightly over three-quarters of the volume and more than half the open interest, with oil companies, physical traders as well as funds and investment companies making up the remainder.

The exchange does not release information on parties involved in delivery but market sources suggest that not only physical traders and Chinese oil majors, but also financial firms like domestic futures brokerages, used the physical settlement mechanism.

It may seem surprising that companies with no use for physical oil have chosen to close positions physically but the settlement process does not require scheduling logistics and chartering vessels. Delivery is typically done by transferring ownership of a warrant – a receipt that allows the holder to take delivery of oil held in a specific tank – from seller to buyer. The seller chooses the grade and location of the warrant they wish to deliver to settle their position.

In a contango market – where prices in later months are higher than the current month – money can be made by selling a later month and buying the current month. This works as long as the profit from this trade is greater than the cost of holding the oil on warrant until it has to be delivered to settle the short position. The Shanghai crude contract was in quite a strong contango for much of the period from November to mid-March, making this trade possible.

The first year of the Shanghai crude contract has been a success in many ways, but from a physical market perspective, it is still early days. There has been talk of independent refiners possibly using Shanghai crude rather than ICE Brent as the basis on which they buy cargoes. But currently there does not appear to be much, if any, use of Shanghai crude as a basis on which to price term contracts or spot cargoes.

On March 22, 131 million barrels of Shanghai crude were traded with open interest of 28 million barrels. ICE Brent saw 946 million barrels traded with open interest of 2.4 billion barrels. This was more than eighty times that of the Shanghai crude and reflects the widespread use of Brent as a risk management tool across the global oil sector.

It is worth remembering that Shanghai crude has only been trading for 12 months – ICE Brent turned 30 last year. As it passes its first birthday the challenge for Shanghai crude will be to draw in more international participation and build market depth and open interest along the curve. It will also take time to build trust in the physical settlement mechanism. But if these issues can be successfully addressed, Shanghai crude may well find its seat at the table with Brent, WTI and Dubai.

When the first premier of the People’s Republic of China, Zhou Enlai, was asked in 1972 about the impact of the French revolution he famously retorted that it was “too early to tell”. History does not relate whether he was referring to the revolt of 1789 or the student riots of 1968, but taking a long view may be wise advice for those trying to judge the success or otherwise of the Shanghai crude oil futures contract.