How Shanghai's International Energy Exchange Could Rearrange the Global Oil Market

Michael Teague |

Slower-than-usual growth from the Chinese economy heading into the second half of 2013 had provided markets with reason enough to be edgy, but those fears have abated significantly as the year draws nearer its conclusion.

During the month of September, for instance, the nation imported a total of 25.68 million tons of crude oil, 6.25 million barrels per day on average, and in October, surpassed the US as the world’s top importer of crude, bringing in some 6.3 million barrels on a daily basis. That this has happened despite a concurrent drop in overall exports has been interpreted as a sign that Chinese growth can indeed be counted on in the near-term at the very least.

But while investors in the West had entertained justifiable concerns about the potential effects of a relatively less exponential growth-trajectory, after having become accustomed to the perks of “Capitalism with Chinese Characteristics,” they may be getting much more than they had bargained for.

Crude Futures Are Only The Beginning

Indeed, a particularly significant piece of news out of Asia on Friday, Nov. 22 went somewhat overlooked as investors celebrated yet another week of big gains on Wall Street. Be that as it may, the Shanghai Futures Exchange announced that its $821 million project to start its own crude oil futures exchange would be ready by the end of the year.

Shanghai is essentially China’s free-trade zone, or, as many in the West would like to believe, the antechamber in which elements of market-capitalism await their acceptance and incorporation into the larger Chinese economy.

The Shanghai Futures Exchange itself is the result of the combination in 1999 of the Shanghai Metal Exchange, the Shanghai Foodstuffs Commodity Exchange, and the Shanghai Commodity Exchange, with the bulk of futures contracts relating to copper, zinc, aluminum, rubber, fuel, and gold. It is currently one of four futures exchanges available to Chinese investors, along with the China Financial Futures Exchange, as well as the Dalian and Zhengzhou Commodity exchanges.

Crude oil futures are not currently traded on any of these exchanges, but the news from last week can be taken as an indication that the Communist(ish) party obviously sees such trading as necessary. It is not terribly difficult to see why; the US Energy Information Administration in early October estimated that China will remain the globe’s top importer of crude oil and other energy products for the foreseeable future, at least until such time as it figures out how to tap its own massive reserves of unconventional oil and gas. It should be noted that a “shale boom” commensurate with China’s estimated reserves would make a mere afterthought of the current US “shale boom”.

Foreign Investment and the Yuan

Since it is the largest importer of energy, however, China doesn’t need a shale boom in order to dramatically affect global oil prices, and two aspects of the soon-to-be-opened Shanghai International Energy Exchange could be especially consequential for global energy prices.

First, the exchange intends to welcome foreign investment. China’s commodity futures market is for the time being almost completely inaccessible to foreign investors. Oil futures, however, are especially dependent upon money from foreign traders as well as oil companies.

It appears that initial outside involvement will be limited to quotas that will expand as the exchange rolls out. It is not impossible to rule out this model eventually being used to bring foreigners in to other Chinese futures markets.

The second and intertwined aspect of the upcoming exchange is to be found in a statement by Yang Maijun, the Chairman of the Shanghai Futures Exchange who, at a recent industry conference, indicated that the futures contracts would be based on the type of medium, sour crude that China most regularly imports, and more crucially, would be denominated in Yuan as well as in US Dollars.

The Consequences of Chinese Economic Reforms

While investors who are generally bullish on China will be more than happy with this sign that the world’s largest country and one of its most important economies is pushing the kind of financial reform that would allow for greater levels of foreign investment. But the fact that the country imports so much crude, as well as being a major producer, gives Chinese futures contracts a good chance of becoming a new benchmark, with the same kind of sway over pricing as the well-known WTI, Brent, and OPEC varieties of crude.

Furthermore, the kind of medium, sour crude that China both imports and produces will make it an affordable alternative for neighboring emerging market countries in Asia at the very least. While transactions are set to be denominated in both dollars and yuan at first, it is not hard to see how oil futures could trading could lead to other kinds of commodities trading being done in the yuan as well.

It would be quite a leap from here to the assumption that China is gradually attempting to establish its currency as the world’s reserve over the dollar. Be that as it may, China’s growing economy imports not only great amounts of oil and gas, but also other hard commodities like iron ore and copper, and if/when a substantial portion of the global trade in these products begins to take place in Yuan rather than the dollar, it will not only have greater leverage over global pricing, but  its currency will be on more equal footing with the dollar.

Given the current trade deficit the US is running with China, the consequences of such an eventuality could be rather significant indeed.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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