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.
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.
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
Market is starting to take US/Iran headlines with a pinch of salt. Brent crude rose $2.8/b yesterday to an official close of $112.1/b. But after that it traded as low as $108.05/b before ending late night at around $109.7/b. Through the day it traded in a range of $106.87 – 112.72/b amid a flurry of news or rumors from Iran and the US. ”US temporary sanctions during negotiations” (falls alarm). ”We will bomb Iran” (not anyhow),… etc. While the market is still fluctuating to this kind of news flow, it is starting to take such headlines with a pinch of salt.
We’ll see. Maybe, maybe not. The Brent M1 contract is trading at $110.2/b this morning which very close to the average ticks through yesterday of $110.4/b.
Trump with bearish, verbal intervention whenever Brent trades above $110/b it seems. What seems to be a pattern is that Trump states something like ”very good negotiations going on with Iran”, ”New leaders in Iran are great,..”, ”Great progress in negotiations,…”, ”Deal in sight,..” etc whenever the Brent M1 contract trades above $110/b. An effort to cool the market. These hot air verbal interventions from Trump used to have a heavy bearish impact on prices, but they now seems to have less and less effect unless they are backed by reality.
As far as we can see there has been no real progress in the negotiations between the US and Iran with both sides still standing by their previous demands.
Iran is getting stronger while the cease fire lasts making a return to war for Trump yet harder. Iran is naturally in constant preparation for a return to war given Trump’s steady threats of bombing Iran again. Iran is naturally doing what ever is possible to prepare for a return to war. And every day the cease fire lasts it is better prepared. This naturally makes it more and more difficult and dangerous for the US to return to warring activity versus Iran as the consequences for energy infrastructure in the Persian Gulf will be more and more severe the longer the cease fire lasts. Israel seems to see it this way as well. That the war is not won and that current frozen state of a cease fire gives Iran opportunity to rebuild military and politically.
Global inventories are drawing down day by day. How much? In the meantime the Strait of Hormuz stays closed. There is varying measures and estimates of how much global inventories are drawing down. Our rough estimate, back of the envelope, is that global inventories are drawing down by at least some 10 mb/d or about 300 mb/d in a balance between loss of supply versus demand destruction. Other estimates we see are a monthly draw of 250-270 mb/d. The IEA only ’measured’ a draw in global observable stocks of 117 mb in April with oil on water rising 53 mb while on shore stocks fell 170 mb. But global stocks are hard to measure with large invisible, unmeasured stocks. As such a back of the envelope approach may be better.
Oil products is what the world is consuming. Oil product prices likely to rise while product stocks fall. Strategic Petroleum Reserves (SPR) are predominantly crude oil. Discharging oil from OECD SPR stocks, a sharp reduction in Chinese crude imports and a reduction in global refinery throughput of 6-7 mb/d has helped to keep crude oil markets satisfactorily supplied. But global inventories are drawing down none the less. And oil products is really what the world is consuming. So if global refinery throughput stays subdued, then demand will eventually have to match the supply of oil products. The likely path forward this summer is a steady draw down in jet fuel, diesel and gasoline. Higher prices for these. Then, if possible, higher refinery throughput and higher usage of crude in response to very profitable refinery margins. And lastly sharper draw in crude stocks and higher prices for these. But some 6 mb/d of oil products used to be exported through the Strait of Hormuz. And it may not be so easy to ramp up refinery activity across the world to compensate. Especially as Ukraine continues to damage Russian refineries as well as Russian crude production and export facilities.
Watch oil product stocks and prices as well as Brent calendar 2027. What to watch for this summer is thus oil product inventories falling and oil product premiums to crude rising. Another measure to watch is the Brent crude 2027 contract as it rises steadily day by day as the Strait of Hormuz stays closed and global oil inventories decline. The latter is close to the highest level since the start of the war and keeps rising.
The Brent M1 contract and the Brent 2027 prices and current price of jet fuel in Europe (ARA). All in USD/b
Our back of the envelope calculation of the global shortage created by the closure of the Strait of Hormuz. Note that 3.5 mb/d of discharge from SPR is also a draw. Note also that ’Forced demand loss’ of 2.5 mb/d is probably temporary and will fall back towards zero as logistics are sorted out leaving ’Price demand loss’ to do the job of balancing the market. Thus a shortfall of at least 9 mb/d created by the closure. More if SPR discharge is included and more if Forced demand loss recedes.
Brent is climbing higher. Front-month is at USD 106.3/bl this morning, close to a weekly high and a USD 9/bl jump from Mondays open. This is the move we flagged as a risk earlier in the week: the market shifting from ”a deal is around the corner” to ”this is going to take longer than we thought”.
Analyst Commodities, SEB
During April, rest-of-year Brent remained remarkably stable around USD 90/bl. A stability which rested on one single assumption: the SoH reopens around 1 May. That assumption is now slowly falling apart.
As we highlighted yesterday: every week of delay beyond 1 May adds (theoretically) ish USD 5/bl to the rest-of-year average, as global inventories draw 100 million barrels per week. i.e., a mid-May reopening implies rest-of-year Brent closer to USD 100/bl, and anything pushing into June or July takes us meaningfully higher.
What’s changed in the last 48 hours:
#1: The US military has formally warned that clearing suspected sea mines from SoH could take up to six months. That is a completely different timescale from what the financial market is pricing. Even a political deal tomorrow does not immediately reopen the strait.
#2: Trump has shifted his tone from urgency to ”strategic patience”. In yesterday’s press conference: ”Don’t rush me… I want a great deal.” The market is reading this as a president no longer feeling pressured by timelines, with the naval blockade running in the background.
#3: So far, the military activity is escalating, not de-escalating. Axios reports Iran is laying more mines in SoH. The US 3rd carrier strike group (USS George H.W. Bush) is arriving with two countermine vessels. Trump yesterday ordered the US Navy to destroy any Iranian boats caught laying mines. While CNN reports that the Pentagon is actively drawing up plans to strike Iranian SoH capabilities and individual Iranian military leaders if the ceasefire collapses. i.e., NOT a attitude consistent with an imminent deal!
Spot crude and product prices eased off the early-April highs on a combination of system rerouting and deal optimism. Both now weakening. Goldman estimates April Gulf output is reduced by 14.5 mbl/d, or 57% of pre-war supply, a number that keeps getting worse the longer this drags on.
Demand-side adaptation is ongoing: S. Korea has cut its Middle East crude dependence from 69% to 56% by pulling more from the Americas and Africa, and Japan is kicking off a second round of SPR releases from 1 May. But SPRs are finite.
Ref. to the negotiations, we should not bet on speed. The current Iranian leadership is dominated by genuine hardliners willing to absorb economic pain and run the clock to extract concessions. That is not a setup for a rapid resolution. US/Israeli media briefings keep framing the delay as ”internal Iranian divisions”, the reality is more complicated and points toward weeks and months, not days.
Our point is that the complexity is large, and higher prices have only just started (given a scenario where the negotiations drag out in time). The market spent April leaning on the USD 90/bl rest-of-year assumption; that case is diminishing by the hour. If ”early May reopening” is replaced by ”June, July or later” over the next week or two, both crude and products have meaningful room to reprice higher from here. There is a high risk being short energy and betting on any immediate political resolution(!).
Down on Friday. Up on Monday. The Brent June crude oil contract traded down 5.1% last week to a close of $90.38/b. It reached a high of $103.87/b last Monday and a low of $86.09/b on Friday as Iran announced that the Strait of Hormuz was fully open for transit. That quickly changed over the weekend as the US upheld its blockade of Iranian oil exports while Iran naturally responded by closing the SoH again. The US blew a hole in the engine room of the Iranian ship TOUSKA and took custody of the ship on Sunday. Brent crude is up 5.6% this morning to $95.4/b.
The cease-fire is expiring tomorrow. The US has said it will send a delegation for a second round of negotiations in Islamabad in Pakistan. But Iran has for now rejected a second round of talks as it views US demands as unrealistic and excessive while the US is also blocking the Strait of Hormuz.
While Brent is up 5% this morning, the financial market is still very optimistic that progress will be made. That talks will continue and that the SoH will fully open by the start of May which is consistent with a rest-of-year average Brent crude oil price of around $90/b with the market now trading that balance at around $88/b.
Financial optimism vs. physical deterioration. We have a divergence where the financial market is trading negotiations, improvements and resolution while at the same time the physical market is deteriorating day by day. Physical oil flows remain constrained by disrupted flows, longer voyage times and elevated freight and insurance costs.
Financial markets are betting that a US/Iranian resolution will save us in time from violent shortages down the road. But every day that the SoH remains closed is bringing us closer to a potentially very painful point of shortages and much higher prices.
The US blockade is also a weapon of leverage against its European and Asian allies. When Iran closed the SoH it held the world economy as a hostage against the US. The US blockade of the SoH is of course blocking Iranian oil exports. But it is also an action of disruption directed towards Europe and Asia. The US has called for the rest of the world to engaged in the war with Iran: ”If you want oil from the Persian Gulf, then go and get it”. A risk is that the US plays brinkmanship with the global oil market directed towards its European and Asian allies and maybe even towards China to force them to engage and take part. Maybe unthinkable. But unthinkable has become the norm with Trump in the White House.
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