China`s oil diplomacy moves to bolster its super power status

China, the world`s largest oil importer, announced recently that it will set up a crude oil futures exchange which will be functional by late March`18. The contracts will be traded in the Chinese local currency Yuan and seeks to establish the Chinese oil futures exchange as a challenge to the traditional oil benchmarks like Brent and Dubai crude and the US benchmark WTI.

China has surpassed the USA in the recent past as the highest oil importing country globally with its 2017 imports of 8.4mn bpd surpassing the US imports at 7.9 mn bpd. The key reasons for China moving to the dominant position in the global oil trade are:

a) Oil demand growing at 11-13% fuelled by its GDP growth at around 7.5% annually.

b) Build up its strategic oil reserves across the country as a buffer against oil price fluctuations

c)Surging shale oil production in USA which has led to reduced imports into USA.

Over the last 15-20 years, the global commodities markets has been driven to  large extent by the Chinese demand due to its explosive GDP growth which in turn fuelled China`s energy demand and infrastructure growth. Apart from oil, other base commodities like iron ore, copper concentrates, bauxite and coal have seen very high demand rates and increased imports into China. 

Futures Exchanges in China

In order to have a relevant pricing mechanism, 4 futures exchanges are functional in China under the tutelage of China Securities Regulatory Commission (CSRC) out of which 3 exchanges deal with commodities and 1 exchange in financial futures. The exchanges are:

1.Zhengzhou Commodity Exchange (ZCE, 1993) – trades in agricultural commodities and PTA.

2. Dalian Commodity Exchange (DCE 1993) – trades in agricultural products and industrial products like PP, LLDPE, iron ore, etc.

3. Shanghai Futures Exchange (SHFE, 1999) -  trades in ferrous, nonferrous and precious metals, chemicals and energy products

4. China Financial Futures Exchange (CFFEX, 2006) – treasury bonds, options and futures.

In the last 5 years, China has witnessed substantial increase in volumes being traded on its exchanges. As reported by the China Futures Association, the turnover of futures contracts has doubled from nearly $15 bn in 2011 to nearly $30 bn in 2016.

Objectives for the oil exchange

The stated objective, for the new oil futures exchange, is to set a regional oil price benchmark as China is the largest oil importer globally. However these moves by China will have to be seen from the perspective of China`s ambition to become a global superpower. Like the US in the 20^th century and Great Britain in the 18^th and 19^th century, one of the steps that China is taking towards its path of superpower status is to control the global trade flows.

China`s global ambitions for a superpower status

As per WTO 2016 figures, China controls 13% of the global trade exports and 10% of global trade imports. With its plans for OBOR, which aims to link China to all major nations China aspires to be trade centre of the world very similar to the old days when the silk route trade was one of the dominant trade routes of the world. In the last few years China has made strategic investments in many parts of the world like in Africa and to support its trade flows, it has bolstered its defence presence in key ports in Pakistan, Sri Lanka, etc.

To support the Chinese trade patterns, China also aspires to make the local currency - Yuan to be a global currency and pose a challenge to the US dollar as a global currency. Since 2016, the Yuan is one of the 5 currencies in Special Drawing Rights (SDR) of the International Monetary Fund (IMF) with a 10% weightage. With trade in Yuan. Thus starting an oil exchange in Yuan, China can increase its stake in the global trade flow as the Brent and West Texas Intermediate are dollar denominated exchanges.

Challenges for the proposed oil exchange

On the other side some of the challenges that the Chinese oil exchange would face are:

·  The Yuan has faced many issues of being manipulated by the Chinese government and hence a big question exists over the currency`s movements. Hence many global players will be skeptical pf playing in a Yuan denominated contract given the forex risks and convertibility issues of the currency.

·  Normally, all the oil benchmarks (Brent, WTI and Dubai) are based in a production center and not in a demand center. Hence the liquidity of the trade in the new exchange can be hampered.

·   Since China is a demand center, freight plays an important role in the pricing and hence freight cost effect in the pricing will be unclear. It can be argued that the London Metal Exchange (LME) is based in London when hardly any metal production occurs in the United Kingdom. However, London being one of the major financial centres of the world coupled with the fact that the LME has physical warehouses in many parts of the world helped LME in becoming the global benchmark for metals trade.

Thus China`s move to setup an oil futures exchange is not only control oil pricing but also in tune with China`s global superpower ambitions of becoming a powerhouse like the USA after WW-2 and Great Britain after the Industrial Revolution. Despite challenges, China has time and again proved that it can move against all odds and succeed. Whether the new oil futures exchange will be a success or not – only time will tell!