When the Shanghai International Energy Exchange launched a crude futures contract back in March the oil market kept close tabs on its development.
Would China achieve its goal of establishing the world’s third crude benchmark? The other two being Brent and WTI. Or would the effort fizzle?
Perhaps the INE futures contract would be popular with a domestic crowd eager to make a quick buck, but fail to win-over savvier investors.
Out of the gate things didn’t look great. The fact that volume was scant relative to ICE Brent or NYMEX WTI wasn’t surprising. More concerning was the distribution of open interest.
Nearly all the open interest was on the September contract, which was the first month of delivery to give time for physical inventories to grow.
That characteristic bore the hallmark of Chinese retail investors who focus on a single month. International traders prefer spreading their positions across several months.
In August, ahead of September expiration, the open interest simply rolled to December (Figure 1).
Source: Shanghai International Energy Exchange (INE) via MarketView
After six months of trading, however, the situation seemed to improve. In October, the open interest for three contracts – January, February and March 2019 – all increased (Figure 2).
Source: INE via MarketView
The likely turning point was the INE’s approval of 15 institutions to act as market makers, which was intended to improve liquidity.
One reason why having more institutional investors is critical is because they are more likely to make decisions based on fundamentals than day-traders.
That’s important because for the INE contract to make the leap to benchmark status it must have credibility within the oil market community as being aligned with fundamentals.
That conclusion is derived in part from the contract’s price relative to Brent and WTI. If the behavior looks erratic, that weakens the case for INE futures as a credible instrument for price discovery.
A glance at the history of the three benchmarks since late March shows the INE contract trading independent of Brent and WTI for sustained stretches (Figure 3).
Source: INE via MarketView
Note: Prices normalized March 26,2018
It’s possible this erratic behavior will subside as the trader demographics shift over time. That said, there is one feature of the contract that may hold it back.
Under the contract rules, there are seven eligible crude streams that can be physically delivered. They are all medium sour crude. Six of the seven come from the Middle East. One is a domestic grade (Shengli).
The INE designated eight locations in China where eligible crude can be stored. The supply must come directly from the country of origin, and when it arrives, the barrels are placed in segregated tanks to prevent blending.
Chinese officials issue a warrant to prove ownership and establish this supply as eligible under the rules of the INE contract.
What this means, in practice, is the amount of warranted supply becomes a key metric to watch, especially as the front-month contract nears expiration.
Will there be enough barrels to satisfy delivery requirements? If not, you can expect a spike in prices as sellers rush to close out positions. That’s why some news reports have tracked eligible supply arriving to China from the Middle East earmarked for INE physical delivery.
This underscores a key question: How can the INE futures contract reflect countrywide or regional fundamentals when the physical delivery requirements are so stringent.
And don’t forget, there’s plenty of competition. The list of contracts vying for Asian benchmark status include Dubai and Oman contracts listed separately by Platts and the Dubai Mercantile Exchange.
There is already wide acceptance within the oil market of the Platts Brent/Dubai spread as a meaningful indicator of fundamentals.
Strong Asian demand or Atlantic Basin oversupply can lead to a tighter Brent/Dubai spread, incentivizing supply to swing toward Asia instead of the Atlantic Basin.
In fact, both factors were present this autumn, as the spread narrowed from October to the end of November.
The spread then reset at the start of December heading into the OPEC meeting on expectations the group would deliver a production cut (Figure 4).
Source: NYMEX via MarketView
Indeed, Chinese refinery activity strengthened in October. Crude runs rose from 12.16 million barrels per day in September to 13.12 million bpd in October, and then fell to 12.59 million bpd in November and 12.15 million bpd so far in December.
Ursa and ClipperData calculate implied refinery demand for China on a weekly basis. It is a joint product derived from Ursa inventory and ClipperData shipping flows.
The increase in Chinese refinery utilization this autumn was notable coming at a time when US refiners enter seasonal maintenance.
Greater refinery demand placed downward pressure on inventories. In Shandong Province, the epicenter for China’s independent refiners, inventory draws that began late May extended well into November (Figure 5)
It may be too soon to pronounce the INE contract a success or failure. These are still the early days. What do you think is the likelihood that INE crude futures will achieve benchmark status?