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Contango structure in China crude futures may spur Dec physical profit-taking

Singapore — A contango structure in China's crude oil futures market may have spurred some buyers to settle September paper positions for physical barrels last week as higher indications for December contracts opened the door to profit-taking in forward months, physical and derivatives traders said this week.

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Trading in September-delivery crude oil futures, or SC1809 contracts, expired at end August and a total 1,202 lots have since been settled by the exchange of physical barrels delivered into storage tanks designated by the Shanghai International Energy Exchange or INE.

The INE said physical settlement for September futures contracts was completed by last Friday, with a total 601,000 barrels of Middle Eastern sour crude oil changing hands between buyers and sellers exercising warrants. The total value of the settlement was Yuan 293 million ($42.6 million), INE said.

A trading source with Chinaoil said the buyers in the physical settlements were all securities and finance companies. China Business Network reported one buyer was state-owned Yongan Futures. The INE does not identify buyers.

The market structure flipped to contango August 21, when the price spread between September and December futures contracts on the INE settled at minus Yuan 17.40/b, swinging from a settlement at a premium of Yuan 4/b the day before.

The September-December contango structure widened further to minus Yuan 41.80/b on August 31, when the front-month contract expired at the final settlement price of Yuan 481/b. The December contract price was quoted by the INE at Yuan 522.8/b at the close the same day.

The widening September-December time spread over the last week of August may have provided the impetus for securities and financial players to take advantage of the timespread arbitrage and receive warrants for prompt-month physical barrels for delivery into December contract settlements at a profit, market participants said.

"If the contango spread is wide enough to cover transaction fees and storage rental costs for three months, buyers would of course take the [prompt-month physical] deliveries," said a futures trader in south China.

Storage in INE's delivery facilities costs around Yuan 0.2/b per day, so storing 601,000 barrels of crude oil for three months would cost over Yuan 18/b. This means buyers would need to set aside at least Yuan 20/b of their profit to cover storage and transaction fees, S&P Global Platts calculations showed.

LIQUIDITY THIN FOR FRONT MONTH

Since the expiration of the September contract, liquidity has been flowing into December contracts rather than the front-month October contract.

The December contract has been dominating market liquidity since mid-August, with 348,304 lots traded on September 5.

This is only slightly lower than the highest daily trading volume of 367,998 lots seen for the front-month September contract on August 8, INE data showed. In contrast, the front-month October contract has seen trading volumes average a much lower 223 lots/day to date in September.

"Unlike the major overseas derivatives markets, the front-month contract is not the most actively traded in China. They usually trade contracts for three months forward, which would allow trade participants more time to speculate and assess their risks," the futures trader said.

"INE futures are currently more like a speculative instrument than serving as a barometer of China's overall crude demand strength," the trader added.

International market watchers noted there may be a correlation between INE futures and the Dubai physical market trading mechanism.

"The underlying asset for INE crude futures are Middle Eastern sour crudes, so some may focus on the third-month contract as it best reflects the Dubai market trading cycle that trades cargoes loading two months forward," a source at a European trading firm based in Singapore said.

The Dubai spot market trades cargoes loading two months ahead; it typically takes around 20-35 days for tankers to reach China from major Persian Gulf crude terminals.

--Analysis by Cindy Liang with Gawoon Philip Vahn, philip.vahn@spglobal.com

--Edited by Wendy Wells, wendy.wells@spglobal.com