China moves to make the grade as a setter of oil price

Talking about a 19th-century political dispute, the British prime minister Lord Palmerston said: “Only three people have ever understood the business – one is dead, one has gone mad and I have forgotten.”

His words seem equally fitting to describe the arcane technicalities of pricing crude oil. Yet the way oil is priced is set for a major shake-up – and the Arabian Gulf’s leading oil exporters will be affected. It is in their grasp to shape this change, or to be passive bystanders.

The change in crude pricing is led, as in so many other energy affairs these days, by Asia’s rising demand – and, in particular, the growing heft of China. In October 2014 and again in April this year, Chinese traders were extremely active in buying up grades of Middle East crude that are used to set prices. They might have had valid needs for the oil, but it is at least as likely that they wanted to support “paper” – purely financial – trading positions.

International crude has long been priced by reference to three grades: West Texas Intermediate (WTI) from the US, Brent from the UK’s North Sea and Dubai. WTI and Brent are traded on regulated futures exchanges, making the market transparent and highly liquid.

It has become increasingly clear, though, that these benchmarks have problems. Due to the expansion of US shale oil production, and that country’s ban on exports, WTI has become a landlocked crude whose value is at times well below that of comparable international crudes.

Production from Brent is declining, and more fields have to be added to the basket of valid supply sources, but it is still vulnerable to “squeezes” by traders who can buy up cargoes to corner the market, and to random factors such as bad weather, technical glitches, strikes and even anomalies of South Korean taxation.

Most importantly, both Brent and WTI are light, sweet (low sulphur) crudes, very different from the heavier, sour (high sulphur) crudes produced in the Middle East that are now the dominant diet for Asian refineries.

The Dubai Mercantile Exchange (DME) has consequently positioned its Dubai-Oman crude contract as a possible Middle East-Asian counterpart to Brent and WTI. But it has still not attracted the same levels of interest and liquidity as its older rivals. Apart from Dubai and Oman, Middle East producers still price most of their crude using opaque assessments of the market by specialist reporting agencies.

So now China has stepped forward. The Shanghai International Energy Exchange is launching its own crude oil contract – where the buyers, not the sellers, would be the key players.

Shanghai’s contract has major problems – in particular, neither Kuwait nor Saudi Arabia have opted to support it, and it is denominated not in dollars like the Brent, WTI and DME contracts, but in yuan (which is non-convertible, and exposes traders to currency risk). Most of all, it will be dominated, at least at first, by the big Chinese traders, notably Unipec (Sinopec’s trading arm) and Chinaoil (the subsidiary of China National Petroleum Corporation). Although the market is slowly opening up, few other companies have the right to import crude oil into China.

Still, China is too big to ignore. And as a major buyer, its interest would naturally be in the direction of lower prices. As recent stock market intervention suggests, it is hardly inconceivable that the Chinese government would take an interest in a contract for such a strategic commodity.

The DME and Shanghai contracts are not incompatible – indeed, the two exchanges have signed an agreement to cooperate. But if Middle East countries, presumably with Opec as the key venue, do not decide a common front on pricing their oil, they risk being picked off individually, and drawn inescapably into using the Chinese exchange. On this esoteric formula rides billions of dollars.

Robin Mills is head of consulting at Manaar Energy and author of The Myth of the Oil Crisis

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