China’s New Crude Benchmark

Economics, Geopolitical, Premium POM

How Iranian Oil & Saudi Dollar Peg Will Change the World of Energy

By JC Collins

At some point in the first quarter of 2016 China will introduce their version of London’s Brent and the WTI crude futures contracts.  The Shanghai International Energy Exchange (INE), a third international crude benchmark, will price energy in renminbi and will serve as an alternative to the western dominated contracts.

Alternative benchmarks have been attempted before, and Russia is attempting to develop its own benchmark based on the ruble.  The challenge which any new and alternative benchmark will face is one of sustained liquidity.  The internationalization of the Chinese currency and its inclusion into the Special Drawing Right basket of the International Monetary Fund will create a yuan liquidity market which can support the INE through the initial start-up phase.

The Executive Board meeting of the IMF to decide the fate of the RMB will be held this Monday, November 30th, and it is expected that the renminbi will be included in the SDR.  The initial weight assigned to the Chinese currency is ranging from 10% upwards to the 14% and 16% range.

Regardless of the initial weight, the status change for the renminbi will be obvious.  Though SDR inclusion doesn’t give the currency immediate reserve status, it does validate the broader internationalization and growing demand, which will lead to further foreign exchange reserve accumulation.

This demand for the renminbi will create a large enough liquidity market to support not just the new Chinese denominated benchmark, but also the large financial support required to fund the BRICS Development Bank and Asian Infrastructure Development Bank.  It is now expected that China will create over $1 trillion dollars’ worth of funding for construction projects in other emerging markets.

Also in the first three months of 2016 it is expected that the economic sanctions on Iran will be lifted and that country will then be able to begin exporting large amounts of crude.  Currently Iran has crude condensate sitting at sea in tanker ships.  It is assumed that Iran will have to discount this condensate by at least 10% to 20% in order to move the product and make room for new production, which it will plan on ramping up in the first 3 to 6 months after sanctions are lifted.

Most analysts predict that this additional crude coming to market, along with the price reductions on the condensate, could push prices even lower.  Unfortunately for Saudi Arabia the existing low crude prices have put pressure on the kingdom, which has already experienced a large decline in its foreign exchange reserves.

This decline is because the Saudi riyal is maintained at a peg with the US dollar of 3.75:1.  The lower the price of crude goes, in addition to an increasing USD, and the pressure to maintain the dollar peg increases, which pushes the country further into deficit spending.

Saudi Arabia could cut production which would help lift crude prices, but would lose market share at the same time.  This is not a good strategy, and an alternative scheme involving China is likely unfolding.

Most arguments are made supporting a Saudi de-peg from the USD, while other arguments favor maintaining the peg.  Both positions make a reasonable case. On one hand, ending the dollar peg would prevent further drawdown on reserve assets, but on the other hand a de-peg would lead to capital outflows, undermine investor confidence, and cause domestic inflation, which would offset most gains realized from an increase in exports.

Another option would be for Saudi Arabia to adjust the peg as opposed to ending it.  The riyal could re-peg at a higher level.  While it would maintain an adjusted peg with the USD, Saudi Arabia could find itself in a position where it would need to export some crude priced in RMB so it wouldn’t have to cut production and lose market share.

Both Russia and Iran are likely to price their crude in RMB and capitalize on the new Chinese denominated benchmark.  Just like the monetary world will experience a shifting of official reserve compositions, so will the crude benchmarks, as futures contracts shift more towards the east.  This shift will not happen suddenly, or overnight, it will take years, with Saudi, and other major exporters, selling crude in multiple denominations at the same time.

The internationalization of the renminbi is about more than the Chinese currency.  It is offering the international monetary system an alternative to USD denominated assets and benchmarks.  Markets which are shifting towards the renminbi will experience a steady growth of liquidity which will lead to sustainable contracts and valuations.

The weight of the RMB in the SDR could potentially slow down the growth of the liquidity market for the Chinese currency.  This would give the US additional time to sort out fiscal budgets and deficits.  But with the strategic positioning by both China and Russia, as well as the implementation of renminbi liquidity markets, including the AIIB and INE, it’s only a matter of time before the economic shift manifests into an obvious geopolitical shift in how the world is organized.  – JC