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Chinese Oil Futures 2.0

May 8, 2018
Editor(s): Gavin Cheng
Writer(s): Abrar Samen, James Lee, Kaavya Jha

Introduction

China finally has their very own oil futures contract after many years in the making, which marks a significant milestone for China’s oil industry and their economy as a whole. With the currency denominated in yuan and specific grades of oil chosen to match the requirements of local refineries, the new contract will better suit local businesses and their needs. China has recently surpassed the US as the lead importer of crude oil, although they are yet to overtake the US in terms of oil consumption. However, they come at a close second, with yearly increases emphasising China’s continued reliance on oil.

The contract will trade according to local times, making it easier to conduct trades throughout the business day for local businesses. The contract will be traded on the Shanghai International Energy Exchange which facilitates transactions in energy derivatives. Although complex, derivative transactions, or specifically futures contracts in our case, are designed with a key focus to help reduce price uncertainty.

Essentially, an oil futures contract is designed to lock in a price of oil today with the actual transaction occurring at a later date. This way, purchasers of the oil are protected against sudden increases in the price of oil, and likewise, sellers of oil are protected against sudden decreases in the price of oil. However, with future contracts such as the London’s Brent Crude Futures and Texas’ WTI Crude Futures already set up, what is the Chinese government’s incentive to introduce their own futures contract?

 

Higher currency liquidity

The adoption of the oil futures contract will see more transactions in yuan, bolstering the liquidity of the currency and helping reduce volatility. This will better prepare the yuan to absorb shocks in the local or global economy, which may arise from falling commodity prices or a decrease in demand for China’s exports. Foreign exchange risk will also be reduced. With a more stable currency, the yuan is better able to weather fluctuations, allowing foreign investors to invest in China without worrying too much about the value of their investment eroding due to large unfavourable movements in the exchange rate. Also, shocks in the global economy may see a flight of capital from countries perceived as being riskier to countries perceived as safer. Having a stable and highly transacted currency will help establish China as a less risky country to invest in, facilitating capital inflows.

Another point to note is that bid-ask spreads may be reduced due to a higher volume of currency transactions. Essentially, a bid-ask spread is the difference between the buy and sell price of a currency. For example, a bidder can purchase 6.3648 CNY for 1 USD, or sell 6.3668 CNY for 1 USD. The bid-ask spread will then be 0.002 CNY for 1 USD, and such a transaction will be facilitated by market makers. Market makers are in the business of facilitating trades by taking both the buy and sell side of a transaction and earning the difference. In highly liquid markets, there is greater competition for market makers as they attempt to outdo each other, resulting in a lower bid-ask spread to the benefit of investors. This will contribute to a more efficient market and encourage investors to invest.

Issues and concerns

Trading began on the 26th of March at 9:00 am local time with an initial surge in trading volumes, marking a successful start to trading despite initial scepticism. Although things are going well so far, there are some concerns with the oil futures contract going forward.

Users may face the prospect of high price volatility when conducting oil futures trades in China despite the increase in liquidity. This is because of a large number of speculators partaking in trades on top of ordinary hedgers. Whereas hedgers consistently take part on either the buy or sell side of the trade to reduce risk in their core business, speculators freely gamble on the price of oil, taking buy or sell sides as they see fit. If most speculators take one side of the transaction, then supply and demand mechanics will induce large changes in prices. In fact, volatility was the major reason why China’s last oil futures in 1993 had to shut down after only one year in operation.

However, this risk should not be as severe the second time around. China has, since then, gained plenty of experience with speculators investing in a wide variety of Chinese markets from nickel and steel reinforcement bars to iron ore. Initiatives such as reducing the available physical delivery space for oil as well as setting high storage costs will help discourage excessive speculation without affecting hedgers too greatly, although this must be done in moderation considering that speculators perform a vital role in markets by contributing to liquidity.

To ensure there is enough liquidity in the market, trading will be closely monitored with trades occurring at discrete time intervals as opposed to continuous trading, which may help to concentrate liquidity to certain times of the day. To further support liquidity, China has encouraged state-controlled oil majors such as Sinopec and PetroChina to participate in trades.

China has also been known for intervening in markets. Due to their concerns about excessive speculation, government interventions have been introduced included more stringent trading rules, higher fees and very limited available trading hours in the past. For example, larger clients who are placing orders of more than 300 lots (30,000 barrels of oil) are limited to 50 lots a day.  This differs from other exchanges which place limits on ratios based on trading volume. Furthermore, China has significant capital controls in place. There have been restrictions imposed by China ever since a large amount of money left the country following a shock devaluation of the yuan. In the stock market, some of China’s interventions included the imposition of ‘lock-ups’ to prevent mass selling in declining markets, as well as banning short selling.

The currency of transaction is another concern. As the USD is the main currency of exchange for global transactions, trading in yuan may result in greater exchange rate risk for foreign investors. This may subdue some of the activity in the Chinese oil futures contracts as foreign investors look to higher transacted currencies such as the US dollar or the British pound.  Adding to this issue is the history China has of intervening in their currency. However, Beijing has declared that they will not devalue their currency to gain an advantage over competitors, and have in recent times engineered an appreciation of their currency with respect to the US dollar. Although these are positive signs, it remains to be seen whether such sentiments persist in the future.

The new oil futures contract shows promise given initial enthusiasm. Although concerns exist with regard to regulatory intervention, it doesn’t preclude its successful development, with contracts for other commodities proving successful in the past. Although the last oil futures contract was unsuccessful, the Chinese government is more prepared this time around to successfully launch its contract going into the future.

The CAINZ Digest is published by CAINZ, a student society affiliated with the Faculty of Business at the University of Melbourne. Opinions published are not necessarily those of the publishers, printers or editors. CAINZ, our Partners and the University of Melbourne do not accept any responsibility for the accuracy of information contained in the publication.