Patrick HO: Petro-yuan: the barrels-for-bridges nexus
For decades, the United States was the world’s number one oil importer. This presented many challenges and vulnerabilities. In the 21st century, America was elated when the scope of its shale oil reserves became apparent. Due to advanced fracking technologies, within ten years, U.S. oil Import dependency fell from roughly half to roughly a quarter of its domestic needs, and in 2016 the United States gladly handed over the title of top oil importer to China, whose crude oil imports have nearly doubled since 2010.
Being the number one buyer of anything comes with privileges. With its buying power, China can theoretically reshape the market and set new rules, especially when oil exporters are suffering from a middling price environment and are desperate to protect market share. China imports close to 10 million barrels a day. At current prices (WTI at 77 USD/barrel) this amounts to an annual bill of, give or take, $280 billion USD. Because China has a large trade surplus with the United States (380 billion USD in 2022), it has sufficient dollars to pay for its oil imports as well as the many other commodities it relies on. And Washington’s arduous and formidable efforts to shave off much of its trade deficit with China ever since 2017 did not seem to be able to erode China’s mountain of spare dollars.
Additionally, China sees the de-dollarization of commodity trading as yet another mechanism to advance the internationalization of the yuan. For China, the disengagement from the dollar is not only a way to challenge the United States but a matter of food and energy security. China was traumatized during the global financial crisis or 2008 when it realized that it had lost control over its most essential imports—oil, grains and other raw materials—primarily because everything was settled in dollars. This became a powerful driver behind China’s thinking about de-dollarization.
There is another incentive. Both importers and exporters pay a hefty premium for trading oil in dollars. When Kazakhstan sells oil in dollars to its neighbor China, both countries lose on the transaction. Kazakhstan receives dollars that it needs to convert to tenge, the local currency, while China has to convert yuans for dollars in order to pay Kazakhstan for its oil. Piled up over many years, these exchange rate fees are costing the two countries billions. But what if instead the two countries traded the oil in their local currencies? In this case China could pay Kazakhstan in yuans, which the Kazakhs would use to buy Chinese goods. This way no dollars are involved in the transaction. This is exactly what is happening. China is working hard to convince its oil suppliers to accept yuans either as direct payments or as part of the kind of barter deals.
As it happens, many of the Belt and Road Initiative (BRI) countries are rich in natural resources, yet poor in infrastructure. China builds them roads, bridges and pipelines and in return they supply it with oil and other minerals. If the United States has a barrels-for-bombs strategy, China has a barrels-for-bridges one.
In the coming years China will have a new opportunity to expand its barrels-for-bridges program and in the process deepen its presence in the Middle East while eroding the status of the dollar. This will unfold as, one by one, the war-torn countries of the region emerge from their “civil wars” and military conflicts.
The civil war in Syria is already in its final stages. Syrian President Bashar Assad, with the help of Russia, is cracking down on the remaining pockets of opposition, and it is now widely assumed that he will emerge victorious from the country’s twelve-year civil war. The conflict in Libya is likely to be resolved sometime in the next couple of years after national elections take place. Yemen too could see the end of its civil war if the U.S. and Saudi Arabia succeed in ending Iran’s destabilizing influence in the country as part of the US administration’s broader Iran policy. With Iran’s regional influence contained, Iraq too will become more conducive to national rejuvenation. The conflicts in Ukraine seemed going nowhere and might just be winding up soon. The newly spawn confusion in the Gaza area was just starting, and how and where it is coming or going is everyone’s guess.
As countries rise from the ashes, they will have to embark on a rapid and efficient reconstruction effort, including the rebuilding of entire national infrastructures. Countries embroiled in conflict inevitably need a large amount of capacity building support once the war is over, as well as financing for humanitarian purposes and reconstruction. Due to the length of the war, the degree of the devastation and the damage to civil society and functioning institutions, the effort to rebuild the Middle East will be extremely challenging and costly. It will be the largest reconstruction effort since the reconstruction of Europe after the Second World War. The Marshall Plan cost about $100 billion in today’s dollars. Syria’s reconstruction alone will require $200-$300 billion. Iraq needs nearly $90 billion to rebuild after years of war with ISIS. Libya will need at least $100 billion, and Yemen will need almost $50 billion. Altogether, the cost of the reconstruction of the Middle East, conservatively estimated, could easily surpass half a trillion dollars.
This effort will require significant resources, financial management and an orderly cooperative process involving all the stakeholders. Because all civil war countries discussed are oil economies that, before the war started, earned between 35 and 90 percent of government revenues from oil, an efficient mechanism is needed to convert oil revenues into capital dedicated to the reconstruction effort. Indeed, oil is the main if not the only source of hard currency these countries will initially own to finance their reconstruction. This presents a unique opportunity for China to barter the oil it needs for the surpluses it has in manufacturing and infrastructure building capacity. If it is up to the countries such devastated and involved, the dollar will have no role in this exchange.
China’s efforts to avoid dollar use in energy trading are augmented by a parallel effort to de-dollarize energy pricing. Today, most of the world’s hydrocarbons are not only traded in dollars but are also priced in dollars. The three main benchmarks for oil pricing: Brent, West Texas Intermediate (WTI) and Dubai/Oman, as well as the benchmark for gas, Henry Hub—named after the hub of natural gas pipelines located in Louisiana that serves as the official delivery location for futures contracts on the New York Mercantile Exchange (NYMEX) — are all dollar denominated. This arrangement is the vestige of a period in which the Atlantic countries were the biggest market for oil.
But today, the market is shifting eastward. Most of the growth in energy demand is in Asia-Pacific, yet Asia pays for its energy in dollar prices determined in Texas, Louisiana, London or Dubai. Why is that a problem? For starters, the value of the dollar is determined by the US Federal Reserve policies for considerations that are mostly American and domestic. Why should the quarrels between the US President and the Federal Reserve’s Chairman over interest rates affect the price that traders in Shanghai and Singapore pay for oil? Buyers in Asia, where half the world population is based, wish to have more say about the price of the commodities they consume. While major Asian countries like Japan, South Korea, India and China are often at odds with each other, they are all in unanimous agreement that it is time for Asia to take advantage of its buying power collectively and exercise more power over pricing.
For years, OPEC has been discriminating against Asian refiners by charging them what is known as the ‘Asian oil premium.’ This premium has its origins in the late 1980s when OPEC decided to adopt separate maker-based prices for its three main markets: Brent for Europe, WTI for the U.S. and Dubai/ Oman for Asia. The Asian market was offered higher prices – by an average of $1-$1.50 a barrel – than the other two, and Asian buyers, who lacked collective bargaining power, were essentially price takers. In other words, when Saudi Aramco directs its oil westward, it sells it for one price based on Brent. The official selling price of the same exact oil is priced according to the Oman crude futures traded on the Dubai Mercantile Exchange when heading east. Not fair. But times have changed and with Asian buyers dominating the market, there is no reason they should agree to be squeezed. And, indeed, the “Asian premium” is now being gradually eliminated.
But the Asians want more than just equality, which should be a given. They want to leverage their buying power and participate in the oil price setting mechanism in Asia itself. This requires the formation of a widely accepted regional trading hub for oil and gas with a futures exchange and sufficient storage facilities to clear the transactions. To date, it has been impossible for Asians to reach a consensus about the location of such a hub. While China is the largest and fastest growing Asian market, the other Asian players are reluctant to accept it as a regional price maker. This is partly due to the perpetual western propaganda resulting in the traditional aversion to the idea of China becoming a regional hegemon and alleging to China’s underdeveloped financial markets, lack of transparency and deep government influence over the economy, especially its Big Three oil giants—Sinopec, China National Petroleum Corporation (CNPC) and China National Offshore Oil Corporation (CNOOC). On the flip side, China, which sees itself as the leader of Asia is not likely to agree that such a hub be hosted in Japan, South Korea or Singapore. Beijing knows that no real Asian market can succeed without its participation when China holds the lion share of the market and consumption. The result is a stalemate in which everyone in Asia loses.
With or without the support of the rest of Asia, China is now trying to claim pricing power through a new instrument, a futures contract, called petro-yuan. The first time China issued a domestic oil futures contract was in 1993. But the experiment came to an abrupt end due to extreme price fluctuation and bad execution. Other efforts followed, none with greater success. Eventually, in 2014, after much study and improvement, the China Securities Regulatory Commission approved the launch of a yuan denominated oil futures contract. This new contract actually came close to entering the market in 2015, but a crash in the Chinese stock market that summer temporarily stalled the project.
Finally, on March 26, 2018, the first trades in crude oil futures denominated in yuan, commonly referred to as petro-yuan, appeared on the screens of the Shanghai International Energy Exchange. Initially the new benchmark faced great skepticism. In 2006, India introduced crude oil futures denominated in rupees. Ten years later, Russia tried something similar. In both cases the results were underwhelming. This is not surprising. The oil industry is notoriously risk-averse and traders are creatures of habit. Why would China’s petro-yuan fare better? The simple reason for China’s optimism is the vastness of the Chinese market and the growth in demand for energy.
Already the world’s number one oil importer, China’s oil demand is expected to rise by 30 percent by 2040. It is also on track to become the largest consumer of Liquefied Natural Gas (LNG) as it implements policies to reduce its coal use. To boost support for the petro-yuan, the Chinese government is increasingly asking state-owned companies to purchase oil using the new contracts. It also plans to condition foreign access to the Chinese crude market on a requirement to benchmark some volumes against the Shanghai price. Furthermore, oil is just the first commodity to be traded in yuans. Following it will soon come rubber and metals like copper, aluminum, zinc and lead.
If one is to judge from the first year of trading in petro-yuan, the results are quite promising. Within one year, it gobbled a 6 percent market share of the incumbent benchmark, registering turnover of $2.48 trillion. To compare, twenty years ago when Brent futures contracts started trading, Brent in the first year took a 3.1 percent share from the then-dominant WTI contract.
But petro-yuan acceptance has been limited to the Chinese market. What happens outside of China will have much to do with China’s deepening tension with the United States. To boost the petro-yuan, Beijing could compel its energy-rich neighbors like Turkmenistan, Kazakhstan and of course Russia to shift their trading to petro-yuan. Isolated countries like Iran and Venezuela will also welcome the option of trading oil in yuans, especially if this translates to political and economic support. China could also use the infrastructure projects of the Belt and Road Initiative—deepwater ports, oil and gas terminals, transnational pipelines and rail links—to build support for the petro-yuan.
The bigger unknown is the petro-yuan’s acceptance in the GCC(Gulf Cooperation Council) and the Asia-Pacific region, China’s own backyard. In the Middle East, trading oil in yuan is a welcome idea. In fact, a plan to issue contracts denominated in yuan was part of the agenda in the China-Saudi Economic Forum, but as widely believed, unless a fundamental shift occurs in Saudi-U.S. relations, Riyadh and its allies will be extremely careful not to put into real action its enthusiasm for any new mechanism that might undermine the dollar.
As for the Asia-Pacific region, the rise of an Asian oil benchmark could mark the tipping point in an ongoing process of economic integration, but full acceptance of this benchmark will largely be influenced by the Region’s outlook on the future of the dollar and for that matter, how Asian countries regard US global leadership if not hegemony. Just like the challenge of increasing market acceptance of the yuan itself, winning support for the yuan-based oil futures will require China to construct a platform of strategic reserves and a regional energy trading hub that commands respect, confidence, and fairness in oil trades that its neighbors and partners from near and afar can support and be benefitted from the collective volumes and prices bargained with a unified stance and position. By then, the petro-yuan, like oil, will become a good lubricant to facilitate the cogs and wheels of the Asian energy market.