March 28, 2018 / 10:30 AM / 25 days ago

EXPLAINER-Shanghai crude futures complete globalization of oil markets

SINGAPORE, March 28 (Reuters) - China’s launch of a crude oil contract this week on the Shanghai Futures Exchange (ShFE) allows investors for the first time to take advantage of differences in supply-demand dynamics across world oil markets.

Oil markets have until now been dominated by two financial futures instruments: U.S. West Texas Intermediate (WTI) and Europe’s Brent crude.

WTI is the main benchmark for U.S. crude grades and a crucial hedging tool for the U.S. oil industry. Brent, priced off North Sea oil, is the primary value marker for Europe, Middle East and African crudes. Both are used extensively by industry and financial traders.

Asia so far has lacked a financial instrument despite its position as the world’s biggest and fastest-growing oil consumer. Previous attempts to establish one have been made in Singapore, Japan and Dubai, but have not been widely taken up.

Shanghai crude futures may have done the trick, though, if traded volumes this week hold beyond initial enthusiasm.

Success in Shanghai would mean the three main global oil markets - Asia/Pacific (APAC), Europe, Middle East and Africa (EMEA), and the Americas (AMERS) - each have a benchmark reflecting their distinct supply-demand drivers.

China’s oil demand makes up more than a quarter of Asian consumption and nearly a tenth globally.

“Hopefully, it (Shanghai crude) gets a lot of traction and we end up with three established global benchmarks,” said Greg McKenna, chief market strategist at futures brokerage AxiTrader.

ARBITRAGE TRADING

One of the main attractions of having globally available crude oil futures is for financial traders to take advantage of regional prices without investing in physical oil or operating assets such as tankers, oil fields or refineries.

Investors typically take advantage of differences in cross-regional prices through arbitrage trading. Before this week, the primary means of doing this in crude markets was via a financial product CL-LCO1=R based on the Brent-WTI price spread.

In EMEA, Brent futures are heavily influenced by output policy from the Middle East-dominated Organization of the Petroleum Exporting Countries (OPEC), as well as by Russia, the world’s biggest oil producer.

Since both OPEC and Russia have been withholding production since 2017 to prop up prices, the spread currently reflects a premium that Brent holds over WTI.

In the Americas, meanwhile, U.S. oil production has jumped by a quarter since mid-2016 to 10.4 million barrels per day (bpd) C-OUT-T-EIA, further supporting the Brent-WTI gap.

Now, investors can also trade the arbitrages between China and the rest of the world.

It would have been profitable this week, for example, to “buy the spread” between higher-priced Brent and lower-priced Shanghai by going long in the European contract and shorting Asia’s as the spread widened from $1.60 a barrel on Monday to $4.60 on Wednesday. That means closing the positions would have gained an investor $3 per barrel.

A spread can be sold as well. Had a trader gone short Shanghai but long lower-priced WTI, it would have yielded a gain of $2.80 a barrel, as the gap between the two narrowed from $3.10 a barrel on Monday to just 30 cents on Wednesday.

Buying WTI while selling Shanghai would effectively replicate in financial markets the surge in actual U.S. crude exports to China seen in the last two years.

HEDGING

Crude futures also offer industry participants like oil producers and petroleum refiners the chance to protect their assets through what is known as hedging. So far, this has been done through the U.S. and European benchmarks.

A Chinese refiner importing Middle East crudes - which are mostly priced off Brent - and needing to protect itself from a sudden jump in prices for those grades, would typically buy Brent futures. That way, losses from higher raw material costs can be mitigated by gains made in the European crude futures.

Now, the Shanghai contract offers risk control strategies better reflecting local demand and supply. Should Chinese fuel demand fall and dent the refinery’s sales that would likely also pull down Shanghai crude futures.

A short position in Shanghai futures would profit from the decline, offsetting at least some of the drop in revenue the refiner would see in its petroleum sales.

Oil producers, by contrast, need to protect crude output from falling prices. Thus, a U.S. shale producer selling into Asia could take a short position in Shanghai to offset any drop in income from physical crude sales if demand and prices unexpectedly fall off in Asia.

Reporting by Henning Gloystein; Editing by Tom Hogue

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