Petroyuan: A fledgling with the potential to soar

By Ding Heng

Almost a year has passed since China launched yuan-denominated crude oil futures contracts on the Shanghai International Energy Exchange (INE), and there are signs that the contracts are being quickly accepted into a market long dominated by the New York-traded West Texas Intermediate (WTI) and the London-traded Brent.

A truck carries imported crude oil. [File photo: VCG]

By the end of 2018, the Shanghai contracts had grabbed an estimated 6 percent of global market share. To put this into a historical perspective, Brent took just a 3.1 percent share from the dominant WTI in the first year after its launch in 1988. Because the INE is in Shanghai's free trade zone, the yuan-priced contracts are open to foreign investors. Well-known international commodity traders Glencore, Mercuria, Trafigura, and Freeport Commodities were among the earliest traders of the contracts.

An oil futures contract specifies a certain amount of crude that will be delivered at a fixed price on a future date. By buying or selling such contracts, traders usually look to hedge against financial risks created by future oil price movement. The fact that international oil traders are treating the Shanghai contracts seriously is probably a sign that they foresee a time when at least part of their business will be invoiced in China's yuan. In order to better prepare for that future, the Shanghai contracts are an opportunity they must grasp.

For decades, the U.S. dollar has been the default currency for pricing and trading in the global oil market. In 1974, the United States and Saudi Arabia signed an agreement that obliged the Saudis to only accept dollars for all its oil sales, in exchange for military protection from the United States. In 1975, dollar-only trading was extended to all of the members of the Organization of Petroleum Exporting Countries (OPEC). This created what became known as the petrodollar system, giving the United States the extraordinary privilege of being able to use its own currency to purchase oil, while other countries that need to buy oil have to build their own dollar reserves.

If it weren't for its geopolitical and military strength, the United States might not have been able to strike the 1974 agreement with Saudi Arabia. But at its core, that deal, and the petrodollar system that followed, was based on the fact that the United States was the dominant buyer of oil at the time. The United States consumed more oil in each year of the 1970s than China consumes today. From 1965 to 1973, its yearly crude imports surged by almost threefold to meet exploding demand.

Today, things are different in many ways. Over the past decade or so, the United States has almost doubled its domestic crude production capacity using shale oil technologies, which in recent months made the country a net oil exporter for the first time in 75 years. This means that it no longer needs to buy as much crude from the outside as it used to. Instead, China has become the world's largest oil importer, with nearly 70 percent of its demand currently met by imports of crude. And that demand is expected to grow from the current level of about 600 million tons per year to more than 750 million tons per year by 2040, according to BP. With limited domestic production capacity, China is likely to continue to rely largely on crude imports in the short run. Another event on the horizon is that India is set to become the biggest source of global oil demand growth by 2024, according to the consultancy group Wood Mackenzie. From a purely commercial perspective, it's questionable whether the U.S. dollar should continue to be used as the default currency in global oil trade.

Geopolitical tensions are playing an equally significant role in prompting some countries to seriously consider moving away from dollar-denominated oil trading. On the minds of oil traders is the decision by the United States to re-impose sanctions on Iran, which is home to significant oil reserves, after U.S. President Donald Trump withdrew from the 2015 Iran nuclear deal despite the strong opposition of other signatories. Even before the U.S. withdrawal, Iran made it clear that it would prefer to settle its trade in currencies other than the dollar. Other signatories to the nuclear accord, including Russia, Germany, France, Britain, and China are to varying degrees in agreement with Iran's position. On Friday, Germany, France and Britain announced that they have set up INSTEX (Instrument in Support of Trade Exchanges), a mechanism allowing“legitimate trade”with Iran to continue in the wake of US sanctions.

In the long term, we may see a multipolar global oil trading system emerge, in which all the major currencies play some role. The yuan will potentially become one of these poles because of China's huge demand for oil and the large number of overseas oil fields owned by China's energy companies.

Some of China's oil partners have already started settling part of their crude deliveries to China in yuan. Gazprom Neft, Russia's third largest oil company, began doing so in 2015. Angola, which agreed to accept the yuan as its second currency in 2015, is mulling over doing the same. A report by UBS last year even expects Saudi Arabia to soon invoice oil exports to China in yuan. Russia, Saudi Arabia, and Angola together make up around 40 percent of China's crude imports.

When it comes to oil purchases that don't involve China, it will take more time to convince traders to use the yuan. To help make this happen, China's currency should be more convertible, and market forces should play a bigger role in determining its value. China's government has been cautiously pushing ahead with these reforms, and its efforts were rewarded in 2016 when the International Monetary Fund added the yuan to its Special Drawing Rights basket so that other countries can include the yuan as one of their official reserve currencies.

If a petroyuan system can take shape, it is expected to facilitate foreign investment in China's energy sector. As foreign oil companies amass more yuan-denominated accounts, they will naturally look for more investment opportunities in China in industries they are familiar with. On the policy front, China is taking steps to try to make that happen. Many people believe that China's oil industry is monopolized by state-run companies, but that's no longer true. Except for a few fields like crude exploration, other fields have been opened to foreign investors. BP, for example, has already said that it will open 1,000 new gas stations across China over the next five years, after China's retail oil sector was fully opened in mid-2018.

The petroyuan system is in its infancy. But substantial global trading of oil paid for with the yuan is an increasingly likely reality that we need to start planning for now.

Note: Ding Heng is a current affairs reporter with China Plus. The article reflects the author's own views.