RMB-denominated oil contracts began trading for the first time in Shanghai on March 26. We believe that in the long term this will ultimately change how oil is traded globally, create a Petroyuan currency flow, increase the role of the RMB as a global trading currency, and compel investors to up their allocations to Chinese financial assets.
Why now?
From March 26, seven oil grades will be tradeable on the Shanghai International Energy Exchange (INE), allowing Chinese buyers to buy forward in RMB. Since INE is based in Shanghai's Free Trade Zone (FTZ), foreign traders will be allowed to trade in the market.
China passed the U.S. as the world's largest oil consumer in 2016. Accordingly, China wants to pay for its huge import bill in its own currency (RMB) rather than USD.
More importantly, however, China wants the new oil trading plan to promote RMB internationalization, i.e. forcing wider adoption of the RMB as a global trading currency, and switching to RMB payments for major imports is part of this process.
The emergence of Petroyuan - RMB-denominated revenues collected by the world's largest oil producers - is a natural development from this process
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Will this new system change the way oil is traded globally?
Probably not in the short term. Traders can't move RMB freely in and out of the Shanghai commodity exchanges yet. That said, it's unclear how much of a roadblock this is given that INE will be based in the Shanghai FTZ. Related: U.S. Oil Exports Are Only Heading Higher
Also, even with exchange convertibility, international investors and resource trading companies need to build up enough confidence in the INE as a trading hub. That requires time and, crucially, the tried, tested, and extensive data infrastructure to support the market, which China doesn't have right now.
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That said, in the longer term, we believe that RMB oil trading will shift the structure of the global oil market, provided two things happen.
Firstly, China will have to remove, or substantially reduce, capital controls for RMB-priced oil trading to take off and allow global commodity trading houses access to the INE.
We think this is already in process, although happening gradually, based on recent policies to make the RMB more market-determined and ease rules on foreign banks' RMB businesses.
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China's other landmark changes, like giving institutional investors direct access to the Chinese bond market, expanding access via the Bond Connect program in 2017, and launching the Shanghai and Shenzhen Stock Connect links with Hong Kong, show the government is intent on the necessary reforms to open the economy to international investors.
Secondly, China's oil trading partners, like Saudi Arabia, Russia, and Iran, will have to agree to accept RMB for their oil exports to China. This is also taking shape because Russia already accepts RMB for oil exports, as does Iran, and we expect Saudi Arabia to soon begin invoicing China in RMB.
The Petroyuan – why it really matters
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Oil trading in RMB is as much about politics as practicality.
The 2008 Global Financial Crisis (GFC) taught the world and China that an over-reliance on key commodities priced in USD can be risky. When USD prices of key commodities rose following the GFC, higher food and energy import bills risked supply security, something a country like China can't afford.
As well as protecting food and energy security, China wants a more active role in global politics and the global economy. As the world's second largest economy, it wants global systems, like oil trading, to reflect China's status.
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Historically the U.S. has been the dominant oil consumer, and oil trading reflects this because it is priced in USD. In the 1970s, Saudi Arabia and the U.S. bilaterally negotiated oil trade settlement in USD and this gave birth to the Petrodollar world we still live in today. Related: The Top Natural Gas Players In 2018
This way of trading has given the U.S. what's been described as an 'exorbitant privilege' – where oil exporters recycle their dollar receipts back into U.S. financial markets, keeping US interest rates low and supporting persistent current account deficits.
But that's about to change – especially now that China has become the largest global oil consumer. China's role is only expected to increase, since BP forecasts annual demand will grow 30.6 percent to 753 million tons per year in 2040, while the U.S. will likely reduce their reliance on oil imports by developing domestic shale oil capacity.
As the dominant customer, particularly for major oil exporters like Russia, Venezuela, Iraq, Iran, and Saudi Arabia, China's market means leverage, and many of these suppliers have either already agreed to price their sales to China in RMB, or are actively considering it.
If, or rather when, China's total oil import bill gets priced in RMB, that's going to create large piles of RMB reserves in oil exporting countries that will either be spent on Chinese exports, or recycled into China's financial markets, giving China much more heft in the global economy.
This will have two principal effects: increased demand for RMB assets and a switch out of the USD for trading purposes, which will likely undermine the United States' dominant role in the global economy and create a sea change in global asset allocation to China's financial markets.
And that's why the launch of oil trading contracts in RMB really matters.
By Hayden Briscoe via Zerohedge.com
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There is no doubt that the petro-yuan will undermine the petrodollar’s dominance in the global oil market.
China has been planning for years to dethrone the US dollar. The truth of the matter is that China does not plan to allow the US financial system to dominate the world indefinitely. Right now, China is the number one exporter on the globe and the largest crude oil importer in the world and also the world’s biggest economy with a GDP of $23.57 trillion in 2017 (compared to $19.38 trillion for the US), based on purchasing power parity (PPP).
The Chinese would like to see global currency usage reflect this shift in global economic power. At the moment, most global trade is conducted in US dollars and more than 60% of all global foreign exchange reserves are held in US dollars. This gives the United States an enormous built-in advantage.
With major oil exporters finally having a viable way to circumvent the petrodollar system, the US economy could soon encounter severely troubled waters. First of all, the dollar’s value depends massively on its use as an oil trade medium. When that is diminished, we will likely see a strong and steady decline in the dollar’s value.
The petrodollar is backed by Treasuries, so it can help fuel US deficit spending. Take that away, and the US economy will be in trouble leading to a loss of value of the dollar against other currencies. Contrast this with a petro-yuan convertible to gold.
The launching of the petro-yuan could be a “wake up call” for the United States. Moving oil trade out of the petrodollar into the petro-yuan could take initially between $600 billion and $1000 billion worth of transactions out of the petrodollar. Maintaining the petrodollar is America’s primary goal. Everything else is secondary.
The petrodollar system provides at least three immediate benefits to the United States. It increases global demand for US dollars. It also increases global demand for US debt securities and it gives the United States the ability to buy oil with a currency it can print at will. In geopolitical terms, the petrodollar lends vast economic and political power to the United States. China would like to emulate this dynamic.
Hitherto, the US dollar has had the monopoly over oil contracts as it enjoyed the status of the only currency in which major oil contracts could be made. This meant that US could get away by having a $21 trillion budget deficit as it could print the dollars backed by “black gold”.
With the petro-yuan a reality now, China will, in effect, be making a claim to global oil reserves. That would definitely be against American interests as the “black gold” has been practically backing the US dollar as well as a humungous US debt.
Still, it won’t be easy for the petro-yuan to unseat the petrodollar without the participation of some major oil producers like Russia and Saudi Arabia. Russia is already on board along with Iran and Venezuela.
China is now trying to persuade Saudi Arabia to start accepting the petro-yuan for its crude oil. If the Chinese succeed, other oil exporters could follow suit.
I suspect that President Trump’s recent attack against Saudi oil is a warning to Saudi Arabia not to start accepting the petro-yuan instead of the petrodollar for payment for its oil exports to China and countries of the Asia-Pacific region.
On balance, I think Saudi Arabia will compromise by accepting the petro-yuan for oil exported to China and the Asia-Pacific countries whilst continuing to accept the petrodollar for exports to the European Union (EU) and the United States. Even such a compromise will still tip the balance in favour of the petro-yuan since 75% of Saudi oil exports go to China and the Asia-Pacific region.
The imposition of tariffs on Chinese goods could be the first shots in the petro-yuan/petrodollar war of attrition. If a trade war between China and the United States erupts, China will not run from a fight with the United States and will retaliate by imposing its own sanctions on US exports. And to punish the United States financially, China could also offload its holdings of US Treasury bills estimated at $1.3 trillion.
It is probable that the yuan will emerge as the world’s top reserve currency within the next decade with the petro-yuan dominating global oil trade.
Dr Mamdouh G Salameh
International Oil Economist
Visiting Professor of Energy Economics at ESCP Europe Business School, London
So be careful what you wish for.