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Analys

A two currency oil market

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SEB - Prognoser på råvaror - CommodityChina today launched its long awaited yuan denominated oil contract at the International Energy Exchange (INE) in Shanghai. Seven crude streams from UAE, Qatar, Oman, Yemen Iraq and China will define the pricing of the contract. There is substantial scepticism towards the contract. Most of the sceptical arguments will in our view dissipate over time as rules, regulations and capital controls are adapted and adjusted as time goes by. The Chinese government likely has plenty of leverage to make the contract a success making it into an Asian oil benchmark representing a vibrant and growing oil demand which today accounts for 27% of global demand.

Bjarne Schieldrop, Chief analyst commodities at SEB

Bjarne Schieldrop, Chief analyst commodities

The launch of the contract will open up for international participation in China’s commodity market for the first time. International oil players will need to hold renminbi books reflecting an oil market which here onwards will roll on two currency wheels.

The rapidly rising risk that Donald, Mike and John will tear up the current Iranian nuclear deal in mid-May makes it likely that Iran will accept crude oil settlement in renminbi in not too long in order to avert the risk of renewed dollar sanctions which it experienced so painfully from 2012 to 2015.

Price action: Brent jumps while equities fall as Venezuela and Iran supply risk increases on John Bolton

The front month Brent crude oil contract jumped 2.2% on Friday to $70.45/bl on news that John Bolton was replacing Lt. Gen. H:R: McMaster as the US national security advisor. John Bolton is known to be abrasive, undiplomatic, deeply conservative and nationalistic with hawkish views on Iran and North Korea. As such he matches both Donald Trump and his new secretary of state Mike Pompeo. It is now difficult to see how the Iran Nuclear deal can survive beyond mid-May when a new round of US waivers is needed to carry the deal forward yet another quarter, unless of course the deal is significantly re-worked. Apparently however the non-US signatories to the Iran nuclear deal are still in the dark with respect to what and how Donald Trump want’s the deal to be re-written. The May waiver deadline is approaching rapidly and as far as we know there is no real work in progress in order to re-work the deal. The appointment of John Bolton also increases the risk for sanctions towards Venezuela. Venezuela’s oil production and export is already in free fall but hanging on a thread by US refineries who are supplying Venezuela with naphtha in exchange of heavy crude oil. Venezuela would not be able to export much oil without the naphtha or light crude which is critical for diluting its heavy crude to a quality which is exportable. Thus US oil sanctions towards Venezuela would cut the last thread.

A two currency oil market

After years and years of waiting the Chinese Yuan denominated oil contract quoted at the Shanghai International Energy Exchange (INE) is finally here. China did try to launch an oil futures contract back in 1993 but it basically blew up due to uncontrollable price volatility. This time around China has taken good time to prepare the launch of its new oil contract in order to make sure that there is no second round flop like in 1993. China last year became the world’s top oil importer with an average import of 8.4 m bl/d. At the same time it is also the world’s sixth biggest oil producer with an average production last year of 3.8 m bl/d.

Seven crude streams in the INE contract with characteristics close to the Dubai crude slate

Seven deliverable crude streams in Shanghai will be used to settle the INE crude oil contract. They originate from UAE, Oman, Qatar, Yemen and China itself. The crude streams are distinctly different from the light, sweet crude benchmarks of Brent crude and WTI. The INE crude streams are on average (across the different grades) required to have an API gravity of more than 29.6 and a sulphur content of less than 2%. In comparison the WTI benchmark is very light with an API of 39.6 and only about 0.24% sulphur. As such the INE benchmark is distinctly different from both Brent crude and WTI. It is however very close to the Dubai crude oil marker which has an API of 31 and a sulphur content of 2%. As such one could say that the INE contract is the Dubai marker in Asia quoted in renminbi.

The new INE contract could be a representation of 27 m bl/d of vibrant Asian oil demand

The new Chinese oil contract will likely over time come to represent Asian oil demand in general. In 2018 Asian demand is set to average 27 m bl/d (IEA) or 27% of global consumption. It has been argued that the new benchmark will be a bad price hedge for oil deliveries in other places in Asia than Shanghai. This is based on the assumption that the oil price fundamentally is set either in the US (WTI), in the Gulf (Dubai marker) or in Europe (Brent). And as such it should mathematically be better to hedge with one of these three price points rather than the new Chinese INE contract. However, if the driver of the global oil market and thus oil price dynamics is instead really set by the vibrant oil demand in Asia rather than the three mentioned oil price benchmarks then it would clearly be better to hedge with the INE contract.

In our view the new INE contract is not an effort to replace the existing global crude oil benchmarks. It is instead filling a needed vacuum in the global oil market: A marker for the Asian market. It has been argued that the existing crude benchmarks are successful since they are located at hubs with both large production and consumption. But this is also actually true for the new benchmark with China being the sixth largest oil producer in the world as well as the biggest oil importer in the world.

The INE contract has several disadvantages but these are likely to dissipate over time

To start with the INE contract seems to have several disadvantages. It will have limited trading hours with the last trading slot ending at 0700 am GMT and thus just before the London market opens. The Chinese government has also set crude oil storage costs at twice the global average level in order to avoid excessive price volatility due from potential games between the physical market and the new INE contract. Such high storage costs will be negative for the necessary interplay and price discovery between the local physical market (derived from storage economics) and the INE financial instruments. Another reason for the very high storage cost may be to avoid commodity storage games used for shadow financing and circumvention of capital controls which has flourished for other commodities traded in China. The quotation of the INE contract in renminbi will also be a negative as seen by most current oil market participants in the current dollar dominated oil market. And lastly Chinese capital controls and unpredictable regulations will also be a concern for many potential participants.

Many of these negatives will however dissipate over time. Trading hours will expand, storage costs will normalize, general capital controls will ease and rules and regulations will stabilize. And lastly the renminbi will be more and more accepted currency world-wide. The Chinese government does have time to adjust and the current mode of the INE market is launch phase with some trail and error. The front month INE contract is actually the September 2018 contract allowing plenty of time for adjustment. So we do not think that one should judge the contract in the early phase on the many negative traits which have been highlighted.

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Plenty of participants ready to transact – Open interest will be the measure of success

More than 6,000 trading accounts have been opened for the INE contract including China’s largest oil companies and 150 brokerage firms. Larger foreign financial institutions like J.P.Morgan have also opened accounts. To further attract foreign participants the Chinese Government has waived income taxes for foreign investors for the first three years. An addition attraction of the INE oil contract is that it will be the first time foreigners will be able to trade commodities in China.

We agree that over time it will be the size of the number of open contracts and not turnover per se which will be the sign of success for the contract. So the open interest in the INE contract will be the parameter to watch. It will be the fingerprint showing that the INE contract fills a need and is actively used as a hedging tool.

The Chinese government has power to tilt the market towards the new contract

The Chinese government has a lot of power in order to ensure that the INE contract becomes a success with widespread use. The easy way is of course to demand that all domestic crude oil purchasing is done with settlement versus the INE contract benchmark. In that way any oil producer who would like to sell oil to China would have to accept the INE contract and settlement in renminbi. China could of course also lean on the countries who cooperate with China on the Belt and Road Initiative (BRI) with six major infrastructure projects in overdrive this year. Asking the involved countries in these BRI projects to use or support the new INE oil contract could be a natural request.

We think that the launch of the INE contract in China is a natural development reflecting that China is the world’s top oil importer, the sixth largest oil producer and a natural benchmark for oil prices in Asia. However, essentially what it all boils down to is that China wants to be able to purchase its oil in renminbi. There are several countries already on-board: Russia, Venezuela, Nigeria and Angola are all already selling oil to China in renminbi. We assume that UAE, Oman, Qatar, Yemen and Iraq also are accepting renminbi as payment for crude delivered to China since six of the seven crude streams in the INE contract originates from them.

No Iranian crude slates in the INE contract yet but Iran should be a natural participant

It is surprising to see that there are no crude oil streams from Iran in the new INE contract. The Iran Heavy crude stream with API = 30.2 and Sulphur = 1.8% should be a natural match the INE crude slate profile.

Iran is one of the countries which have been heavily hit by the weaponized USD. In 2012 the US applied pressure through the SWIFT system. It blocked clearing for every Iranian bank, froze $100 billion of Iranian assets which together with other measures helped to block Iranian oil exports which roughly dropped 1 m bl/d due to this.

US pressure is building up against the Iran nuclear deal – should naturally drive Iran towards the INE contract

Now pressure is rising rapidly towards Iran. In the US forces are gathering to tear apart the Iran nuclear deal with the recent appointment of Mike Pompeo as US secretary of state and John Bolton as the US national security advisor. Donald Trump together with these two now looks ready to tear apart the current Iran nuclear deal as waivers are up for renewal in mid-May. The Saudi crown prince Mohammed bin Salman also seemed to apply pressure against Iran at his meeting with Donald Trump. Thus Saudi Arabia seems like it is sticking with the US while Iran, Iraq, Oman, UAE, Qatar and Yemen are drifting over towards China. China and the US are at the same time drifting apart amid increasing trade tensions with political tensions in the South China Sea being the icing on the cake so to speak. It seems highly plausible in our view that Iran in not too long with explicitly state that they also accept payment in renminbi for oil sales to China.

Saudi Arabia however seems for the time being to stick even tighter to the dollar-oil deal which the House of Saud presumably struck with Nixon and Kissinger back in 1974 in exchange for protection and geopolitical support.

Crude slates in the INE contract

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Crude slates in the INE contract

Ch1: Yes, the INE September contract started to trade first time on 26 March 2018

INE September contract started to trade first time on 26 March 2018

Ch2: Brent crude went opposite of equities last week

Brent crude went opposite of equities last week

Ch3: Weekly US, EU, Singapore and Floating stocks lower 2nd week

Weekly US, EU, Singapore and Floating stocks lower 2nd week

Analys

All eyes on OPEC V8 and their July quota decision on Saturday

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Tariffs or no tariffs played ping pong with Brent crude yesterday. Brent crude traded to a joyous high of USD 66.13/b yesterday as a US court rejected Trump’s tariffs. Though that ruling was later overturned again with Brent closing down 1.2% on the day to USD 64.15/b. 

Bjarne Schieldrop, Chief analyst commodities, SEB
Bjarne Schieldrop, Chief analyst commodities, SEB

US commercial oil inventories fell 0.7 mb last week versus a seasonal normal rise of 3-6 mb. US commercial crude and product stocks fell 0.7 mb last week which is fairly bullish since the seasonal normal is for a rise of  4.3 mb. US crude stocks fell 2.8 mb, Distillates fell 0.7 mb and Gasoline stocks fell 2.4 mb.

All eyes are now on OPEC V8 (Saudi Arabia, Iraq, Kuwait, UAE, Algeria, Russia, Oman, Kazakhstan) which will make a decision tomorrow on what to do with production for July. Overall they are in a process of placing 2.2 mb/d of cuts back into the market over a period stretching out to December 2026. Following an expected hike of 137 kb/d in April they surprised the market by lifting production targets by 411 kb/d for May and then an additional 411 kb/d again for June. It is widely expected that the group will decide to lift production targets by another 411 kb/d also for July. That is probably mostly priced in the market. As such it will probably not have all that much of a bearish bearish price impact on Monday if they do.

It is still a bit unclear what is going on and why they are lifting production so rapidly rather than at a very gradual pace towards the end of 2026. One argument is that the oil is needed in the market as Middle East demand rises sharply in summertime. Another is that the group is partially listening to Donald Trump which has called for more oil and a lower price. The last is that Saudi Arabia is angry with Kazakhstan which has produced 300 kb/d more than its quota with no indications that they will adhere to their quota.

So far we have heard no explicit signal from the group that they have abandoned the plan of measured increases with monthly assessments so that the 2.2 mb/d is fully back in the market by the end of 2026. If the V8 group continues to lift quotas by 411 kb/d every month they will have revived the production by the full 2.2 mb/d already in September this year. There are clearly some expectations in the market that this is indeed what they actually will do. But this is far from given. Thus any verbal wrapping around the decision for July quotas on Saturday will be very important and can have a significant impact on the oil price. So far they have been tightlipped beyond what they will do beyond the month in question and have said nothing about abandoning the ”gradually towards the end of 2026” plan. It is thus a good chance that they will ease back on the hikes come August, maybe do no changes for a couple of months or even cut the quotas back a little if needed.

Significant OPEC+ spare capacity will be placed back into the market over the coming 1-2 years. What we do know though is that OPEC+ as a whole as well as the V8 subgroup specifically have significant spare capacity at hand which will be placed back into the market over the coming year or two or three. Probably an increase of around 3.0 – 3.5 mb/d. There is only two ways to get it back into the market. The oil price must be sufficiently low so that 1) Demand growth is stronger and 2) US shale oil backs off. In combo allowing the spare capacity back into the market.

Low global inventories stands ready to soak up 200-300 mb of oil. What will cushion the downside for the oil price for a while over the coming year is that current, global oil inventories are low and stand ready to soak up surplus production to the tune of 200-300 mb.

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Analys

Brent steady at $65 ahead of OPEC+ and Iran outcomes

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Following the rebound on Wednesday last week – when Brent reached an intra-week high of USD 66.6 per barrel – crude oil prices have since trended lower. Since opening at USD 65.4 per barrel on Monday this week, prices have softened slightly and are currently trading around USD 64.7 per barrel.

Ole R. Hvalbye, Analyst Commodities, SEB
Ole R. Hvalbye, Analyst Commodities, SEB

This morning, oil prices are trading sideways to slightly positive, supported by signs of easing trade tensions between the U.S. and the EU. European equities climbed while long-term government bond yields declined after President Trump announced a pause in new tariffs yesterday, encouraging hopes of a transatlantic trade agreement.

The optimisms were further supported by reports indicating that the EU has agreed to fast-track trade negotiations with the U.S.

More significantly, crude prices appear to be consolidating around the USD 65 level as markets await the upcoming OPEC+ meeting. We expect the group to finalize its July output plans – driven by the eight key producers known as the “Voluntary Eight” – on May 31st, one day ahead of the original schedule.

We assign a high probability to another sizeable output increase of 411,000 barrels per day. However, this potential hike seems largely priced in already. While a minor price dip may occur on opening next week (Monday morning), we expect market reactions to remain relatively muted.

Meanwhile, the U.S. president expressed optimism following the latest round of nuclear talks with Iran in Rome, describing them as “very good.” Although such statements should be taken with caution, a positive outcome now appears more plausible. A successful agreement could eventually lead to the return of more Iranian barrels to the global market.

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Analys

A shift to surplus will likely drive Brent towards the 60-line and the high 50ies

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Brent sinks lower as OPEC+ looks likely to lift production in July by another 400 kb/d. Brent crude declined 0.7% yesterday to USD 64.44/b and traded in a range of USD 63.54 – 65.03/b. This morning Brent is down another 0.7% to USD 64/b along with expectations that OPEC+ will lift its production quota by another 411 kb/d in July.

Bjarne Schieldrop, Chief analyst commodities, SEB
Bjarne Schieldrop, Chief analyst commodities, SEB

Kazakhstan would be in breach even if the whole 2.2 mb/d of voluntary cuts are unwounded. The eight countries behind the 2.2 mb/d of voluntary cuts, the V8, have lifted their production quotas by close to 950 kb/d from April to June with unwinding starting in April. Over the coming week towards the end of May, the group will discuss what to do with quotas in July. Market expectations as well as indications from within the group is for another 411 kb/d hike also in July. Higher oil demand during summer both in the Middle East and globally is one reason for the hikes. Most of the additional production will not leave the Middle East but be consumed locally this summer. But Kazakhstan is also a major problem. The country produced 1.77 mb/d in April and 300 kb/d above its quota level. To maintain cohesion and credibility the group needs internal cooperation and harmony. Kazakhstan seems to have no plans to reduce production down to its quota. The alternative solution to reestablish internal harmony is to lift quotas up to where production is. The problem is that Kazakhstan only accounts for less than 5% of the overall production of V8. Thus even after unwinding all of the 2.2 mb/d, the quota of Kazakhstan would not rise much more than 100 kb/d. Far from the country’s overproduction of 300 kb/d in April.

A shift to surplus will likely drive Brent towards the 60-line and high 50ies. Losing front-end backwardation implies Brent crude down to the 60-line and high 50ies. Currently the Brent crude curve holds a front-end backwardation premium of USD 1.5/b versus the November price currently at USD 62.6/b. A result of an oil market which is still tight here and now. But if OPEC+ lifts production to a level where the market starts to run a surplus, then the front-end contract will flip from a USD 1.5/b premium vs. 4 months out to instead a comparable USD 1.5/b discount to 4 months out. That would bring the front-end contract down towards the 60-line and the high 50ies. This because a full out contango market usually also will drive the deferred contracts a bit lower as well. But this may not be all doom and gloom. A softer USD and a lower oil price is a powerful combo for global consumption. Global oil stocks are also low. This will help to cushion the downside.

Brent crude forward curve. Surplus and full contango would eradicate the front-end backwardation and drive Brent crude down towards the 60-line and high 50ies.

Brent crude forward curve. Surplus and full contango would eradicate the front-end backwardation and drive Brent crude down towards the 60-line and high 50ies.
Source: Bloomberg graph, SEB highlights
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