China's flawed futures contract pushes oil trade to record high in 2018

https://www.reuters.com/article/us-crude-oil-futures-china-analysis/chinas-flawed-futures-contract-pushes-oil-trade-to-record-high-in-2018-idUSKBN1OB0K7

Shanghai’s new yuan-denominated derivatives contract is set to propel global crude oil futures trading volumes to a record high in 2018, eating into the market share of the two most active crude contracts, Brent and WTI. 

Launched in late March by Shanghai International Energy Exchange (INE), China’s first serious attempt to establish an Asian oil price benchmark has seen strong take-up, grabbing a spot market share of around 6 percent versus international Brent LCOc1 and U.S. West Texas Intermediate (WTI) CLc1, taken equally from both benchmarks. 

Spot crude oil volumes have more than doubled globally over the past five years, but exchange data shows Brent and WTI activity will dip this year for the first time since 2013. 

Brent and WTI volumes slipped to 207.2 million lots of 1,000 barrels each for this year by Dec. 10, down from 220.17 million lots in 2017. 

However, adding 13 million lots of Shanghai crude oil futures ISCc1 to those of Brent and WTI, and last year’s levels have been reached with around two weeks of trading left this year. 

“If a new exchange achieves 6 percent market share vs the two incumbents within the first year of trading that’s fairly impressive,” said John Driscoll, director of Singapore-based consultancy JTD Energy. 

Shanghai crude’s first year will have been better than Brent’s, which took 3.1 percent share from dominant WTI in its 1988 launch-year. 

(GRAPHIC: Shanghai crude oil futures vs Brent & WTI - tmsnrt.rs/2Pu8WeJ)

FLAWED CONTRACT

Despite the successful launch, Shanghai crude futures are fraught with problems preventing them from becoming an efficient hedging tool for oil producers and, ultimately, a benchmark on par with Brent or WTI. 

One of the main issues is a lack of international market participants. 

Matt Stanley, a fuel broker with Starfuels in Dubai, said most participants in Shanghai crude futures were Chinese individuals who don’t trade on market fundamentals. 

“It really has no bearing on the two main benchmarks (Brent and WTI) as it is a Chinese market for the Chinese, not a Chinese market for a global trading audience,” he said. 

Traders said to become more successful, the market needed a more diverse group of participants, including producers, end-users and international shippers to offset the dominance of the Chinese traders. 

“Chinese retail traders follow patterns that we in the oil industry don’t, while China’s oil majors also have very differing interests to us. Add intermittent trading, and this exposes us to the risk of being stuck with positions we don’t want to carry,” said one trader with an international oil major. 

He declined to be named as his company was still in talks on joining Shanghai crude futures. 

Other issues include incompatible trading hours with the rest of the world, including two short sessions between 0100 and 0700 GMT and a night session, and limited physical deliverability of its underlying crude grades in China.

CHOPPY TRADING

Inconsistent trading volumes make it difficult to use Shanghai crude as a financial hedge. 

“For industrial investors, they would need smooth trading of front-month to hedge risks,” said Chen Kai, head of research with Chinese brokerage Shengda Futures. 

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After a roaring start between March and August, front-month Shanghai crude futures virtually stopped trading until November, after which activity picked up again. 

Chen Kai said this behaviour by retail traders was common in China, with similar patterns seen in asphalt and metals futures. 

INE declined to comment for this article. 

To create more liquidity, the exchange is trying to attract so-called market makers, usually major oil producers, merchants or banks, often deployed by international exchanges such as CME Group (CME.O) and Intercontinental Exchange (ICE.N) to generate activity in contracts by providing constant bids and offers on the platform that counterparties can engage with. 

Jiang Yan, chairman of INE’s parent, the Shanghai Futures Exchange, said earlier this month in Shenzhen “gradual improvement of relevant domestic laws and regulations” would in time “greatly enhance” Shanghai crude’s recognition with international investors. 

Outside China, the contract’s denomination in yuan as part of Beijing’s drive to push its currency into global markets has also scared off some traders as it introduces foreign exchange risk to the market. 

To attract international participants, Stanley said a global exchange could “have a look-a-like contract in U.S. dollars, thereby eliminating any FX risk.” 

Stanley pointed to iron ore futures, where Singapore Exchange (SGX) SGX1.SG mirrors a yuan-denominated contract from the Dalian Exchange in U.S. dollars. 

Even without its flaws, some doubt whether Shanghai crude can break the dominance of Brent and WTI. 

“Liquidity is very hard to displace,” said Martijn Rats, Global Oil Strategist at U.S. bank Morgan Stanley, adding that any new product would need some big advantages to sap liquidity from the most active futures contracts. 

JTD’s Driscoll said the jury is still out but added: “It’s likely things will gradually move, mature and develop.” 

Reporting by Henning Gloystein in SINGAPORE; additional reporting by Meng Meng in BEIJING and Florence Tan and Roslan Khasawneh in SINGAPORE; Editing by Sonali Paul