Analys
A two currency oil market

China 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.
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.
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
Ch1: Yes, the INE September contract started to trade first time on 26 March 2018
Ch2: Brent crude went opposite of equities last week
Ch3: Weekly US, EU, Singapore and Floating stocks lower 2nd week
Analys
Whipping quota cheaters into line is still the most likely explanation

Strong rebound yesterday with further gains today. Brent crude rallied 3.2% with a close of USD 62.15/b yesterday and a high of the day of USD 62.8/b. This morning it is gaining another 0.9% to USD 62.7/b with signs that US and China may move towards trade talks.

Brent went lower on 9 April than on Monday. Looking back at the latest trough on Monday it traded to an intraday low of USD 58.5/b. In comparison it traded to an intraday low of USD 58.4/b on 9 April. While markets were in shock following 2 April (’Liberation Day’) one should think that the announcement from OPEC+ this weekend of a production increase of some 400 kb/d also in June would have chilled the oil market even more. But no.
’ Technically overbought’ may be the explanation. ’Technically overbought’ has been the main explanation for the rebound since Monday. Maybe so. But the fact that it went lower on 9 April than on Monday this week must imply that markets aren’t totally clear over what OPEC+ is currently doing and is planning to do. Is it the start of a flood or a brief period where disorderly members need to be whipped into line?
The official message is that this is punishment versus quota cheaters Iraq, UAE and Kazakhstan. Makes a lot of sense since it is hard to play as a team if the team strategy is not followed by all players. If the May and June hikes is punishment to force the cheaters into line, then there is very real possibility that they actually will fall in line. And voila. The May and June 4x jumps is what we got and then we are back to increases of 137 kb/d per month. Or we could even see a period with no increase at all or even reversals and cuts.
OPEC+ has after all not officially abandoned cooperation. It has not abandoned quotas. It is still an overall orderly agenda and message to the market. This isn’t like 2014/15 with ’no quotas’. Or like full throttle in spring 2020. The latter was resolved very quickly along with producer pain from very low prices. It is quite clear that Saudi Arabia was very angry with the quota cheaters when the production for May was discussed at the end of March. And that led to the 4x hike in May. And the same again this weekend as quota offenders couldn’t prove good behavior in April. But if the offenders now prove good behavior in May, then the message for July production could prove a very different message than the 4x for May and June.
Trade talk hopes, declining US crude stocks, backwardated Brent curve and shale oil pain lifts price. If so, then we are left with the risk for a US tariff war induced global recession. And with some glimmers of hope now that US and China will start to talk trade, we see Brent crude lifting higher today. Add in that US crude stocks indicatively fell 4.5 mb last week (actual data later today), that the Brent crude forward curve is still in front-end backwardation (no surplus quite yet) and that US shale oil production is starting to show signs of pain with cuts to capex spending and lowering of production estimates.
Analys
June OPEC+ quota: Another triple increase or sticking to plan with +137 kb/d increase?

Rebounding from the sub-60-line for a second time. Following a low of USD 59.3/b, the Brent July contract rebounded and closed up 1.8% at USD 62.13/b. This was the second test of the 60-line with the previous on 9 April when it traded to a low of USD 58.4/b. But yet again it defied a close below the 60-line. US ISM Manufacturing fell to 48.7 in April from 49 in March. It was still better than the feared 47.9 consensus. Other oil supportive elements for oil yesterday were signs that there are movements towards tariff negotiations between the US and China, US crude oil production in February was down 279 kb/d versus December and that production by OPEC+ was down 200 kb/d in April rather than up as expected by the market and planned by the group.

All eyes on OPEC+ when they meet on Monday 5 May. What will they decide to do in June? Production declined by 200 kb/d in April (to 27.24 mb/d) rather than rising as the group had signaled and the market had expected. Half of it was Venezuela where Chevron reduced activity due to US sanctions. Report by Bloomberg here. Saudi Arabia added only 20 kb/d in April. The plan is for the group to lift production by 411 kb/d in May which is close to 3 times the monthly planned increases. But the actual increase will be much smaller if the previous quota offenders, Kazakhstan, Iraq and UAE restrain their production to compensate for previous offences.
The limited production increase from Saudi Arabia is confusing as it gives a flavor that the country deliberately aimed to support the price rather than to revive the planned supply. Recent statements from Saudi officials that the country is ready and able to sustain lower prices for an extended period instead is a message that reviving supply has priority versus the price.
OPEC+ will meet on Monday 5 May to decide what to do with production in June. The general expectation is that the group will lift quotas according to plans with 137 kb/d. But recent developments add a lot of uncertainty to what they will decide. Another triple quota increase as in May or none at all. Most likely they will stick to the original plan and decide lift by 137 kb/d in June.
US production surprised on the downside in February. Are prices starting to bite? US crude oil production fell sharply in January, but that is often quite normal due to winter hampering production. What was more surprising was that production only revived by 29 kb/d from January to February. Weekly data which are much more unreliable and approximate have indicated that production rebounded to 13.44 mb/d after the dip in January. The official February production of 13.159 mb/d is only 165 kb/d higher than the previous peak from November/December 2019. The US oil drilling rig count has however not change much since July last year and has been steady around 480 rigs in operation. Our bet is that the weaker than expected US production in February is mostly linked to weather and that it will converge to the weekly data in March and April.
Where is the new US shale oil price pain point? At USD 50/b or USD 65/b? The WTI price is now at USD 59.2/b and the average 13 to 24 mth forward WTI price has averaged USD 61.1/b over the past 30 days. The US oil industry has said that the average cost break even in US shale oil has increased from previous USD 50/b to now USD 65/b with that there is no free cashflow today for reinvestments if the WTI oil price is USD 50/b. Estimates from BNEF are however that the cost-break-even for US shale oil is from USD 40/b to US 60/b with a volume weighted average of around USD 50/b. The proof will be in the pudding. I.e. we will just have to wait and see where the new US shale oil ”price pain point” really is. At what price will we start to see US shale oil rig count starting to decline. We have not seen any decline yet. But if the WTI price stays sub-60, we should start to see a decline in the US rig count.
US crude oil production. Monthly and weekly production in kb/d.

Analys
Unusual strong bearish market conviction but OPEC+ market strategy is always a wildcard

Brent crude falls with strong conviction that trade war will hurt demand for oil. Brent crude sold off 2.4% yesterday to USD 64.25/b along with rising concerns that the US trade war with China will soon start to visibly hurt oil demand or that it has already started to happen. Tariffs between the two are currently at 145% and 125% in the US and China respectively which implies a sharp decline in trade between the two if at all. This morning Brent crude (June contract) is trading down another 1.2% to USD 63.3/b. The June contract is rolling off today and a big question is how that will leave the shape of the Brent crude forward curve. Will the front-end backwardation in the curve evaporate further or will the July contract, now at USD 62.35/b, move up to where the June contract is today?

The unusual ”weird smile” of Brent forward curve implies unusual strong bearish conviction amid current prompt tightness. the The Brent crude oil forward curve has displayed a very unusual shape lately with front-end backwardation combined with deferred contango. Market pricing tightness today but weakness tomorrow. We have commented on this several times lately and Morgan Stanly highlighted how unusual historically this shape is. The reason why it is unusual is probably because markets in general have a hard time pricing a future which is very different from the present. Bearishness in the oil market when it is shifting from tight to soft balance usually comes creeping in at the front-end of the curve. A slight contango at the front-end in combination with an overall backwardated curve. Then this slight contango widens and in the end the whole curve flips to full contango. The current shape of the forward curve implies a very, very strong conviction by the market that softness and surplus is coming. A conviction so strong that it overrules the present tightness. This conviction flows from the fundamental understanding that ongoing trade war is bad for the global economy, for oil demand and for the oil price.
Will OPEC+ switch to cuts or will it leave balancing to a lower price driving US production lower? Add of course also in that OPEC+ has signaled that it will lift production more rapidly and is currently no longer in the mode of holding back to keep Brent at USD 75/b due to an internal quarrel over quotas. That stand can of course change from one day to the next. That is a very clear risk to the upside and oil consumers around should keep that in the back of their minds that this could happen. Though we are not utterly convinced of the imminent risk of this. Before such a pivot happens, Iraq and Kazakhstan probably have to prove that they can live up to their promised cuts. And that will take a few months. Also, OPEC+ might also like to see where the pain-point for US shale oil producers’ price-vise really is today. So far, we have seen no decline in the number of US oil drilling rigs in operation which have steadily been running at around 480 rigs.
With a surplus oil market on the horizon, OPEC+ will have to make a choice. How shale this coming surplus be resolved? Shall OPEC+ cut in order to balance the market or shall lower oil prices drive pain and lower production in the US which then will result in a balanced market? Maybe it is the first or maybe the latter. The group currently has a bloated surplus balance which it needs to slim down at some point. And maybe now is the time. Allowing the oil price to slide. Economic pain for US shale oil producers to rise and US oil production to fall in order to balance the market and make room OPEC+ to redeploy its previous cuts back into the market.
Surplus is not yet here. US oil inventories likely fell close to 2 mb last week. US API yesterday released indications that US crude and product inventories fell 1.8 mb last week with crude up 3.8 mb, gasoline down 3.1 mb and distillates down 2.5 mb. So, in terms of a crude oil contango market (= surplus and rising inventories) we have not yet moved to the point where US inventories are showing that the global oil market now indeed is in surplus. Though Chinese purchases to build stocks may have helped to keep the market tight. Indications that Saudi Arabia may lift June Official Selling Prices is a signal that the oil market may not be all that close to unraveling in surplus.
The low point of the Brent crude oil curve is shifting closer to present. A sign that the current front-end backwardation of the Brent crude oil curve is about to evaporate.

Brent crude versus US Russel 2000 equity index. Is the equity market too optimistic or the oil market too bearish?

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