China Syndrome

China Syndrome

By Chris Cook, for Trend

Last week was an interesting week for the oil market for two reasons, which may well be connected.

Firstly, benchmark Brent & WTI oil market prices fell during the week by about 10 percent, and secondly, after maybe six years in the making China finally announced that the long-awaited Shanghai International Energy Exchange crude oil futures contract would commence trading on March 26, 2018.

The contract provides for physical delivery into Shanghai regional storage of seven different crude oil qualities, six from the Middle East and one from China. Moreover, the fact that the contract will be priced in Yuan, with the possibility of gold-backed guarantee of contract performance is widely perceived as an attack on the US dollar, and this has generated a great deal of excitement.

Oil Pricing

Similar excitement, from the same devotees of 'hard' money, became pervasive a dozen years ago in relation to the Iran Oil Bourse initiative to launch a regional oil benchmark contract. It fell to me to debunk this myth, since the Iran Oil Bourse concept was mine in the first place, and I was able to say categorically that the currency in which the contract was denominated was not a consideration. Having said that, Iran's OPEC representative told me at the time in London that Iran had more than once raised the possibility of Euro pricing at OPEC meetings, but this was rejected by OPEC members and Iran went along with that decision.

Anyone familiar with futures contracts will know that the time of trade is not the same as the time of the contract fulfillment, either by physical delivery of crude oil (a complex and time-consuming process involving chartering vessels, inspection & analysis of cargoes, issuance and processing of bank letters of credit and so on) or by payment of a cash equivalent.

At the time when a futures trade is agreed, the currency in which it is priced is typically the dollar, but it could be any currency, since a foreign exchange rate for both a 'spot' and a forward sale of currency against the dollar is always available at rates which reflect the ebbing and flowing of global trade, finance and investment.

Oil Trade Clearing

Oil market participants, such as producers, refiners and physical & financial traders, look to futures exchanges firstly as a trading forum, where they can find liquidity (the ability to find buyers if they wish to sell forward, and vice versa). Secondly, market participants require a guarantee that their counter-party will perform the contract, in a process known as trade clearing & settlement.

In the case of Shanghai, the exchange will ensure (backed by cash or collateral, including gold) that sellers who do not close out their contract through an equal and opposite purchase, actually deliver oil of the right specification to the nominated location on the nominated date. Conversely, the exchange must ensure that the buyer has Yuan available to pay for the oil upon delivery, which is a straightforward domestic issue.

Petrodollar or PetroYuan?

The key question in terms of global finance and the dollar is what the seller does with the oil sale proceeds. For decades from 1973 Oil Shock onward, the US agreed with oil producers such as Saudi Arabia that the dollar credits would be exchanged for US financial assets/obligations, typically US Treasury Bills. In this way Petrodollars came to fund the US trade deficit and provided funding for the US banking system.

The problem for the 'Dollar Killer' thesis for the new exchange is that unless and until China routinely runs a trade deficit then there will be no Yuan reserve assets (Bonds) for which to exchange Yuan and create PetroYuan. Gold backing, while potentially useful as collateral for the exchange's clearing guarantee, is too restricted in supply for gold-backed Yuan to be viable as a reserve asset other than that hugely inflated gold valuations (which are of course the objective of gold investors). I see no possibility that China will cease mercantilist policies which are integral to the business model of China Inc.

To cut a long story short, the same 'hard money' myth which clouded Iran's true motivation for the Iran Oil Bourse initiative also clouds the Shanghai exchange initiative. So what then, is the true reason for the Chinese initiative, and what are the potential outcomes?

Oil as an Asset

I have documented many times both in Trend and elsewhere, how the oil market became transformed in 2001 from a market in a physical commodity to a market in a financial asset, controlled, manipulated and run until 2008 (when the market collapsed) by and for the benefit of oil market physical and financial middlemen who thrived on volatility and opaque Enron-style market tactics. It was for this reason – not any wish to kill the dollar - that Iran wished to establish a more stable and credible Middle Eastern pricing benchmark.

From 2008 onward, President Obama's smart strategy was essentially 'Transition through Gas' – a switch from oil to gas and less reliance upon oil generally and Saudi oil specifically. So, the US deliberately inflated the oil market price, beginning immediately after Obama came to power, and held it for 5 years between $80 and $120 per barrel. This price support was funded by PetroDollar capital and with liquidity from Quantitative Easing (QE) by the Federal Reserve Bank.

The resulting tidal wave of Petrodollars funded development of an additional 5 million barrels per day (mbpd) of US shale oil production as well as massive gas production and investment in renewable energy and energy efficiency, which reduced product consumption by 2 mbpd.

The outcome, as Obama intended, was to free the US from reliance on Saudi Arabia, who had become an embarrassment, and who then – once they realized how they had been foxed by the US - switched reserves to Euro denominated assets in the EU.

But of course, all this changed when President Trump was unexpectedly elected, and in the period since then, a new strategy has been devised, known as Energy Dominance, which was implemented on July 1, 2017. Since then the oil market price has been inflated once again in a financial market bubble by a new market support operation. This time, US shale oil reserves are being monetized more directly, and oil exports have been legalized, so that the US is now able to dominate the oil market by delivering oil into the market in response to oil price increases.

China Syndrome

China's interest in control of oil market price formation dates back to the Obama 2009/2014 oil price bubble, and while the 2014 fall in price relieved the time pressure, preparations have continued for the launch.

In particular, in the last three years, China has added some 800 million barrels of oil reserves, and this gives them all the ammunition they need for an oil price war. Moreover, these financial purchases – combined with routine OPEC and Non-OPEC cheating - have acted to cloud true oil market physical supply and demand.

If I were advising China in relation to making the contract a success I would suggest that they withdraw liquidity from the US controlled ICE/CME oil market platform and switch it to their new contract. This would lead to a fall in the Brent & WTI benchmark prices in Dollars and (via spot FX) in Yuan to levels with which China is comfortable. At that point China could invite other regional oil buyers to join the auction, to which global producers would then be invited to tender offers through the Shanghai Exchange.

The oil price fell last week immediately following the announcement of the Shanghai contract launch, but this may well have reflected US stock market turbulence. On the other hand, there is a possibility that China is already following – for common sense trading reasons – the above strategy.

If so, the next few weeks leading up to the contract launch on March 26 promise to be interesting.


Chris Cook is a former director of the International Petroleum Exchange. He is now a strategic market consultant, entrepreneur and a commentator.

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