FEATURE: INE's Shanghai Crude contract sustains Chinese demand for cheap Middle East barrels

Singapore — Strength in the price of Shanghai crude oil futures hosted on the Shanghai International Energy Exchange, or INE, and a doubling of storage capacity may explain why Iraq's Basrah and Oman have fetched higher prices in a deeply discounted market for Middle East crudes over April.

This month, several million barrels of May loading Basrah Light crude were picked up by Chinese buyers at premiums ranging from $2/b to $3/b against the May Basrah official selling price. The premiums stand in stark contrast to other Middle East crudes of comparable quality, but trading at discounts of under $1/b against their respective OSPs in the spot market.

Additionally, the Dubai Mercantile Exchange's Oman marker has averaged record highs against Platts Dubai crude assessments in April. In the first-quarter, DME Oman averaged 76 cents/b over Platts cash Dubai, but to-date in April the DME Oman marker has averaged $3.14/b above Platts M1 cash Dubai.

Middle Eastern crudes had "pulled up in value as INE values made Oman and Basrah Light diffs very strong," a crude trader based in Singapore said.

More than 10 million barrels of Basrah Light and 4.4 million barrels of Oman have been bought onto warrant since the contract started trading in March 2018, the exchange's data showed. Dubai has never been bought onto warrant and only 504,000 barrels of Upper Zakum have ever been moved into INE tanks.

INE designated storage more than doubled in April to 48.13 million barrels, from 22.03 million barrels at the end of March.

According to one Beijing-based analyst, this expanded capacity together with SC's premium against Middle East crudes would give more opportunity for physical players to bring cargoes onto warrant. According to INE data, the volume of crude held on warrant this month has already reached an all-time high, more than double to 8.2 million barrels on April 28, up from 3.4 million barrels at the beginning of the month.

It typically takes 20-35 days for crude to move from the Middle East to China. A cargo of May loading Basrah would arrive in China in June, then put into an INE approved storage to settle the July SC contract, which expires at the end of June.

SC futures, denominated in Chinese Yuan have traded at a considerable premium to international benchmarks this month. July SC crude futures converted into US dollars, settled at $32.50/b on April 28, a $16.20/b premium over May loading Basrah Light. On the same day, August SC settled at $35.60/b, equivalent to $18.80/b premium to the Platts Oman DME marker.

Freight, insurance, port costs, and 30 days storage in INE designated tanks are currently estimated at just under $7/b, making it profitable to sell July and August SC futures, and buy May loading Basrah Light and June loading Oman cargoes. After arriving in China, these can be put into INE tanks and used to physically settle the short futures positions if required.

The strength of INE crude futures is due in part to strong buying by retail investors, who account for most of the activity on the SC contract.

"Retail investors widely believe crude price to rebound sooner or later," one futures broker said, adding that they could gain exposure from either buying the contract directly through their broker or via futures-linked investment vehicles.

"Even if it will not rebound soon, the price will not fall lower," a Guangzhou-based retail investor, who was long SC futures and believed it was a better way to hedge against inflation than leave cash on deposit at the bank, said.

OPEN INTEREST RISES DOWN THE CURVE

Despite flat price on the front months being stronger than other benchmarks, the SC is in contango, reflecting the weakness of global oil markets.

As of April 28, the spread between the settlement price of the July and August SC contracts was at minus Yuan 21.9/b, while the spread between August and September SC settlement prices was at minus Yuan 20.3/b.

This is well above the cost of Yuan 6/b to hold oil for 30 days in INE storage. Companies that own INE warrants can profit from engaging in a carry trade -- selling the forward month and buying the prompt month -- with the security that their warrants can be used to settle their short positions when they expire.

The attractiveness of this trade is reflected in the level of open interest on SC, which as of April 28 was 185.9 million barrels. This is more than six times the 26.7 million barrels of open interest on February 4 when markets reopened after the Lunar New Year holidays.

Historically, most of the open interest on SC is on the front two months, but as of April 28, 59% of open interest was further down the curve on the July, August and September contracts coinciding with the period that physical cargoes loading over the next one to three months will arrive in China.