Yuan Crude Contract

China launched a yuan-denominated crude oil contract which began trading on the Shanghai International Energy Exchange (INE) on March 26.

If successful, the contract would establish the third major global crude oil benchmark, alongside Brent and West Texas Intermediate (WTI), but more importantly, it could challenge the United States Dollar (USD) as the global currency of the crude oil market. Both Brent and WTI are denominated in USD.

Crude oil is the world’s most traded commodity, and last year China surpassed the United States as the world’s largest importer. The contract is intended to enable China to become more of a price maker of crude oil, as opposed to a price taker, while also internationally promoting its currency in global trade.

Why is oil denominated in USD? In July 1944, amidst World War II, delegates of 44 Allied nations gathered at the Mount Washington Hotel in Bretton Woods, New Hampshire with the goal of creating a new global monetary regime to ensure economic stability and to prevent another revival of trade conflict and war.

At the time, the United States had the world’s strongest economy as well as the largest gold reserves. Built on the commitment of converting USD to gold at a fixed $35/ounce relationship, the USD became the global reserve currency.

And then the 1960s happened. The United States, faced with the exorbitant costs of the Vietnam War and President Lyndon Johnson’s Great Society welfare programs, printed more and more dollars, subsidized by the advantages of it being the global reserve.

Meanwhile, some European nations were beginning to resent America’s exorbitant privilege, viewing the entire monetary system as asymmetrically in favor of the debt-crazed United States. In 1965, French President Charles de Gaulle, outraged at the notion of USD being as good as gold (watch speech here), sent the French navy across the Atlantic to convert US dollars to gold.

By 1971, too many nations were following the French example by demanding the redemption of gold, so in August, President Richard Nixon (watch) terminated the convertibility of USD for gold in what’s known as the Nixon shock. The act unilaterally severed the Bretton Woods system and effectively ushered in the unconstrained current monetary order of freely floating fiat currencies.

The United States, having become addicted to monetary hegemony, needed a new solution. So in 1974, Nixon reached an agreement with Saudi King Faisal, pledging military might to protect the Saudi oil fields in exchange for the kingdom accepting USD for the sale of its oil.

By the following year, all OPEC nations were pricing their oil in USD, and dollars for gold was effectively replaced by dollars for oil. It’s often valuable to view US-Middle East relations through this prism.

Ever since the mid-1970s, the global crude oil trade has been exclusively conducted in USD, even when neither party to a transaction is American. For this reason, the revenues generated by the sale of oil are often referred to as petrodollars.

The USD-denomination of oil creates a huge demand for dollars worldwide, which are then recycled back into the United States, in turn enabling the US to run massive budget deficits while borrowing at low rates.

Moreover, since the world’s most traded commodity is denominated in USD, and thus every nation that wants to purchase it in the global market needs to first obtain USD, it becomes more convenient and logical to price the world’s other most important commodities in USD as well.

Back to today: As China is now the largest importer of crude oil, creating a mechanism to give it more price control is a logical step. The Shanghai contract also better fits the hedging needs of Chinese refiners as it comprises a basket of heavier crudes from the Middle East which they largely import as opposed to the lighter USD-denominated crudes.

And the international promotion of its currency is a central priority as part of China’s Belt and Road Initiative, the large-scale infrastructure development plan devised to establish increased connectivity and both land and maritime trade routes with 64 nations across Eurasia, Oceania and Northern Africa.

So the launching of a yuan-denominated crude oil contract is the first step in establishing a so-called petroyuan system, but challenges still exist.

For it to succeed, the contract will need to attract broad activity from both speculators and commercial hedgers. Many foreign investors remain way of Chinese capital controls and market intervention, so further liberalization of its financial markets may be a precondition for a full-scale embrace by the international speculators.

And while the contract has drawn initial interest from two major commodity trading houses, Glencore and Trafigura, long-term viability of the contract might be incumbent upon convincing major oil producing and consuming nations to accept the idea of unseating the USD for yuan pricing.

For example, China could conceivably leverage its position as the world’s largest crude purchaser of crude oil and approach Saudi Arabia to conduct its sales in yuan, putting the kingdom in the precarious situation of having to decide between losing China as a customer and sparking indignation from the United States.

Or perhaps renewed oil sanctions against Iran following the President Donald Trump’s decision to extricate the United States from the Iran nuclear deal push Tehran to yuan-denominated oil sales and the Shanghai crude contract as a means to circumvent sanctions from Washington.

So can a crude oil contract succeed in a state-managed marketplace? Can a yuan-denominated contract threaten the preeminence of the United States Dollar? Stay tuned.