China wants to disrupt oil with an all-new market

The world's biggest oil buyer finally has its own oil futures.

For 25 years, China had sought but failed to establish its own pricing benchmark for the crude oil it buys and uses.

The country came one step closer to that goal on Monday, when it started trading crude oil futures in local currency, the yuan, challenging the world's dollar-denominated oil benchmarks.

They will be the first commodity futures contracts in mainland China that foreigners can buy and sell.

The move gives China more power in pricing crude oil in Asia, and is part of China's push to challenge the supremacy of the dollar.

Why should I care?

China has been trying to promote the global use of the yuan, which currently accounts for only about 2% of global payments, according to Swift, the global interbank system.

The yuan-denominated futures contracts at the Shanghai International Energy Exchange are the first in mainland China that are fully open to foreign traders.

Allowing foreigners to trade is a “major step within the policy to open up the financial sector, and elevate the yuan within the international environment,” said John Browning, Shanghai-based managing partner at BANDS Financial.

“This is a fundamental change in the Chinese financial market and cannot be underestimated.”

Until today, foreigners had to incorporate a local entity before they could buy or sell any commodity futures in China, such as cotton or soybean futures. 

What else?

As China's economy has grown, so has its oil consumption.

Last year it dethroned the US as the world’s biggest crude importer.

But the two key crude benchmarks have been American and European: West Texas Intermediate, which trades in New York, and Brent Crude, which trades in London.

By starting yuan-denominated crude futures trading, China hopes to wrest pricing power from the two established benchmarks.

“China is building a price benchmark that accurately reflects the ebbs and flows of demand and supply inside China and, beyond that, Southeast Asia,” said Browning.

In 1993, China introduced crude oil futures only to halt trading a year and a half later because of volatility. Since then, it has repeatedly delayed reintroduction due to market instability.

Wait, what are crude oil futures?

Crude oil is one of the world’s most actively traded commodities, refined for use as fuel and for manufacturing countless products.

Oil futures contracts are legal agreements that allow traders to buy and sell oil for delivery in the future. Companies use them to hedge against rising prices; speculators trade them for a profit – if they correctly forecast price movements.

The caveats

Even though China is the top importer of crude oil, its consumption trails both the US and the EU. That limits the country's influence over its pricing.

And the success of the country’s new crude oil futures market will partly hinge on whether there’s enough foreign buy-in.

“A contract with only or mostly Chinese players may succeed in drumming up enough liquidity, but it will be seen as too one-sided. It won’t inspire the market confidence that a regional or global pricing benchmark has,” said Vandana Hari, founder and CEO of Singapore-based Vanda Insights, which provides oil markets analysis.

The Chinese government imposes capital controls, and has occasionally intervened in the market. Foreign investors will have to be willing to swallow those risks.

On the first day of trading on Monday, the first contract went to Glencore, the global commodity trader and mining giant, according to Shanghai-based brokerage Xinhu Futures.