China’s insurance on oil

On March 26 China officially launched his yuan denominated oil futures on the Shanghai Stock Exchange. This event represents a major milestone in the diffusion of Yuan as a worldwide currency. Many analysts affirm that the Chinese long run strategy is to impose Yuan as the new Dollar. The focus on such a target, one that most of the analyst also find quite improbable, makes us lose the focus on what actually means, in the present time, this event.

First things first, we should give a glance to the context this future is born in; these data will come at hand later on in the article. China just became the world biggest importer of crude oil, meanwhile it cover 4% of global export of refined oil. At the same time China’s energy sources are partitioned as follow:

Shares (2016)

Expected Shares (2040)

Change (’90 – 2016)

Expected change (- 2040)

Oil

19%

17%

436%

28%

Gas

6%

13%

194%

Coal

62%

36%

258%

-18%

Nuclear

2%

8%

574%

Renewables and Hydro

12%

26%

~790%

The mainstream interpretation for this move boils down in affirming that through its new role as biggest crude oil importer, China hopes to take a further step toward imposing the Yuan as the global dominant currency. For this to happen the oil futures have to become the new global benchmark for crude. Is it possible?

We can draw from an analogous case of the past: in 2015 nickel was listed on the Shanghai exchange; within 6 weeks the volume of trading surpassed that of nickel in the London Metal Exchange. It was a rapid surge, but still the Shanghai exchange didn’t take the place of a nickel benchmark.

The main reasons behind this failure (if of failure we can talk) are two. The first one is that in Chinese markets speculator play a far greater role than in other exchange markets: their action inflate the volume of trading, but on the other hand they also drive significantly up the volatility of prices for commodities listed in the Shanghai market. This is due to the fact that speculator and similar kind of investors are not interested, nor informed, on what they are exchanged, as long as they only exploit the small differences in bid/ask prices.

The second reason lay in the environment itself of the Shanghai exchange: People Republic of China. Even if we talk about free trade on a market we cannot forget the tight control that China keeps on monetary policy e Yuan valuation, and the even stronger power, with no liability, that the state can exercise on rules.
So, given the highlighted problems, regardless of the futures’ structure and the underlying commodity, it’s quite unluckily that there will be enough developed countries adopting the Shanghai exchange valuation as benchmark and shifting there their main activities. Alone China cannot match the aggregated oil market of the western economies. Moreover from the table above we can see that is not in their plan to expand much further the share of crude oil consumption, thus not even in the future it will have the strength to impose renminbi oil valuation as global benchmark: then it is safe to conclude that the new oil futures in Yuan are not that game-changing instrument in the world currencies panorama.

So if this new oil future is not the big step we hear for imposing Yuan globally, what are the other reasons behind it?

Taking a closer look to the actual energetic situation of China and its international moves we can spot that the main reason behind this future can be a tentative to become more independent from USD policy and western dynamics with respect to Oil imports and consumption.

China is one of the states with the highest energy consumption, and is still growing fast. The sources of energy used are divided as in the table above. We can see that the main source, as of 2016, is coal; its production is almost entirely national, thus coal’s supplies are not a concern for the PRC. Moreover the intense use of coal has cause such environmental and pollution problems that in the Chinese plans its adoption will have a cut, leading it to a secondary role in the energy source panorama.

If on the one hand coal consumption will be reduces, energy demand will keep on growing. This lead to the dilemma on which alternative energy source focus. Is clear since a few years now that China has choose to focus on the development of renewable energies sources: the transition to the green energy will be covered in the meantime with an increasing use of gas and atomic power. In all of this the role of oil will be unchanged: it will keep its role of important source, covering for almost a fifth of the national energy demand throughout the next decades.

Green energy and nuclear power are all endogenous sources, and they don’t expose China to geopolitical supply problems. On the contrary, when it comes to oil, China is the world biggest importer, and this makes it strategically vulnerable. It comes natural then that PRC wants to secure itself from this weakness in its energy supply.

Now let’s briefly analyze what it means for China to buy crude Oil denominated in USD. We know that the price of oil is strictly related to consumption, production, economic growth and goods’ prices. If the price of Oil rise it will affect negatively the economy of a state making everything more costly (just think of the impact on our everyday life the price of oil for cars an transportations). This is even more true for developing countries like PRC with respect to developed countries. This is due to a higher energy efficiency of the latter, that makes consumption and production less susceptible to oil price change, and a higher fuel substitution. So, in simple terms, higher price of oil is bad for China.

Now, taking a step forward, we define the cases in which oil price increases for China. The first basic case is when oil price increase worldwide due to offer-demand dynamics; we won’t deal with this since is not a China related problem, but is a common problem that goes behind the  currency in which is exchanged oil.

The second scenario is the one we are interested in: the monetary policy of the FED, that should influence only American economy, does in fact affect heavily also the world market for crude oil. An expanding dollar policy yields two results: through the interest rate it increase the demand for commodities, and consequently oil, driving up prices. Through the exchange rates makes cheaper to buy dollar denominated instruments and commodities for other currency users; of the two channel the one whose effects prevail in aggregate is the interest rate, thus an expansive policy should rive up the oil price. Naturally the opposite holds for a restrictive monetary policy. An example of this happened right after the 2008 recession: in a tentative to push economy the FED deployed the Quantitative Easing: the result was the skyrocketing of oil price worldwide due to the action of American investors.
Now even if this affects all the countries in the world, we have to account for the dimension of China in the oil market: being the biggest importer of crude oil makes the country heavily susceptible to movements in the price. What makes everything worse is the complete absence of control on any of these dynamics, since all of them are exclusively born from the FED action.

Is not surprising then that China wish to increase its independence from American policies.
To achieve this PCR first launched the first Yuan oil future in Shangai Stock Exchange: this move, in the light of the previous considerations, can be now correctly be interpreted not as step toward the global diffusion of yen, but rather as a step toward the creation of a more dollar/US independent market of crude oil.

So now we can operate on oil using renminbi, and this is the first stone to build such independence. A second stone was already in place, i.e. the potential volume of the oil market going through Shanghai: we said that China is the biggest importer, this means that this new market segment does not born without potential. Now what is missing are the agents and the countries willing to operate in such market.

We argued before that no western country is willing to shift to the Yuan Shanghai Exchange: there are problems in volatility, problems on the liability of Chinese government and its control over laws and capital. So we need to find someone else willing to enter. There are a couple of potential candidates we can analyze.

The first important country that could be willing to operate in the Yuan Market is Russia. Russia is already one of the biggest exporter of crude oil, not to mention it isn’t what we would define filo-american. Operating in the Yuan oil market could gain Russia a big client for its oil, and a potent ally in the geopolitical scene. Moreover Russia already started a ruble denominated market for oil, a market that is sometimes deals with difficulties due to the swinging relations with US. Joining the Shanghai market could give Russia more independence, with the added value of a warrant in the currency of the biggest economy in the world, and the toughest USA competitor.
The second important group that could enter in the Chinese oil market are the African’s subsahariann countries. Is not a news that China is investing a lot to create bounds with those countries, both through aids, participation and funds, like the Chinese-African Development Fund. Moreover we cannot forget that China is one of the biggest buyer in the world for minerals, like copper and zinc, and the main acquirer of the African countries. They have all the interests in keeping sane the relations with China. In addition it cannot be excluded an expansion of the renminbi market to such minerals, consolidating the bound between these two realities.
The last reality that could operate in such market is worth mentioning in light of the latest news: Saudi Aramco is going to have an IPO soon, and PRC is set to make a big offer in the process. This means China is acquiring influence in one of the biggest oil producer of the world. It’s impossible of course that Aramco will leave the Dollar oil market, but still it is also really likely that, if the Chinese participation in the IPO will go down, it will operate somehow also in the Shanghai stock Exchange.

It’s worth mentioning finally those countries that are under American sanction (Iran anyone?), and being forced out of the dollar market will turn to Shanghai.

Everything seems than in place for things to work out. Trump’s politics is more than ever one of surprise, confusion and fast changing ideas; this makes the global scene volatile, and agents operating in volatile environment aways will to insure themselves. China has already some potential candidates to join its initiative in Shanghai, and in the light of this volatility it seems even more likely. The market will probably grow initially slowly, with smaller realities joining after these big early adopters, as Saudi Aramco and Russia. And we will eventually reach an equilibrium sometimes in the future, where US dollar Oil will still be the benchmark, but it won’t be anymore a monopoly. On the other hand the reasons for which the Shanghai oil market could fail to grow are just geopolitical, and lie outside strictly economics ad financial reasons. A lot will depends of the strength relations between USA and the other players in the Oil Market, on the role the US will choose to cover in the global scene, on its ability to keep its old allies near, and to approach those development realities in which also China is investing. If the Yuan oil market in the end will fail, it won’t hurt much China: it will still have a small niche to be partially insured against dollar and US policies. Yuan will be a little bit less global, yes, but is not through financial markets that China has to spread it, so it won’t be such a drawback.

In conclusion this new future won’t be a game changer in the global scene of currencies, not at least in the short run; but has all the potentiality to give a shock to the monopoly of the dollar in the oil world. USD will not lose is lead, but for sure will make America revise its policies and objectives. Just another move on the board, for sure not a check mate, more probably a castling.

(Simone Pasquini)

Bibliography: 

  • https://www.bloomberg.com/news/articles/2018-06-04/china-revives-global-yuan-push-as-capital-outflow-worries-fade
  • bp.com/energyoutlook
  • https://www.bloomberg.com/news/articles/2018-03-25/china-s-oil-futures-are-finally-here-what-you-need-to-know
  • https://www.mckinsey.com/mgi/overview/in-the-news/china-renewable-energy-revolution
  • Yoshino, Taghizadeh–Hesary; International Journal of Monetary Economics and Finance 2014 7:3, 157-174
  • China’s Engagement with Africa From Natural Resources to Human Resources, David Dollar
  • http://www.cadfund.com/en/
  • https://www.bloomberg.com/news/articles/2018-02-14/russia-says-may-invest-in-saudi-aramco-ipo-via-fund-with-china

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