Beijing (JLC), August 8, 2018--JLC has made analysis on the positioning of the most traded Shanghai crude (SC crude) futures contract as well as its reasonable price differential with the benchmark crude prices in Middle East, based on the cross regional arbitrage price anchoring mechanism and spot trading characteristics of SC crude futures deliveries. Related evidence is provided to justify our analysis, based on SC crude trading data since its launch. It will be a long way for SC crude futures to make a success and become a regional crude oil pricing benchmark. To achieve that goal, it is needed to increase the participation of industrial players and organizations, improve the liquidity of forward-month contracts, expand delivery depots and delivery approaches and timely launch trades of price spread contract which can help improve the liquidity.

    1. The global benchmark crude oil linkage under cross regional arbitrage mechanism

    The natural geographical partition of the global markets leaves one single commodity rather difficult to have only one benchmark price. Take the crude oil as an example, BP divides the current international oil market into six major geopolitical blocks, respectively Asia-Pacific, Middle East & Africa belonging to eastern market category, North America, Europe, Eurasia, and South America belonging to western market. Of the six major blocks, North America, Europe, Middle East, Asia-Pacific regions play significant roles in balancing the global oil supply and demand. In the wake of shale oil and gas revolution in the United States, the supply and demand of the western market is generally balanced, and the supply and demand of the Eastern market is also roughly balanced. However, from the perspectives of subdivision, North America has moved from net import to import & export balance. In addition, the supply & demand situation in Europe and Eurasia is roughly balanced. The Middle East region is the biggest oil exporting location whereas the Asia-Pacific region is the biggest oil inflow destination. Currently, North America has its own benchmark crude oil, namely WTI crude oil, of which the price is decided by futures markets with high liquidity. Europe takes Brent crude oil as benchmark crude oil and also has its own independent futures market. The benchmark crude oils in the Middle East region are Dubai and Oman crude oil. So only the Asia-Pacific region hasn’t established independent benchmark crude oil yet, hence the oil pricing for Asia-Pacific region including China basically draws on the other three benchmark oil prices for pricing. The current retail price of oil products in China is adjusted on the basis of the changes in the weighted average of a basket of international benchmark crude oil futures and spot prices.

    The price trend of the three major benchmark crude is in high-positive correlation, of which the fundamental reason lies in that there are frequent cross regional arbitrage between the markets where the three benchmark crude oils are located. The price differentials between benchmark crude oils not only include the price differential caused by quality between benchmark crude oils, but also include regional price differential. Both Brent and WTI crude oils belong to light sweet crude oil, whereas Dubai and Oman crude oils belong to sulfur-bearing medium crude oil. For instance, the price differential between Brent crude oil and Dubai crude oil for the year 2011-2017 ranged between $1-4 /bbl, which can’t be totally interpreted by the quality differential between the two crude oils, and instead, it is because of relative supply-demand balance relationship of eastern and western regional markets. Brent crude oil can be regarded as benchmark crude oil for the western region, while Dubai crude oil can be viewed as benchmark crude oil for the eastern region. The relative balance relationship for both the eastern and western regions is that they keep balanced all by themselves, just like the seesaw. Given that the supply is more than demand in the eastern region market and the supply can’t meet the demand in the western market, the price spread between Brent crude oil and Dubai crude oil will be widened, which will facilitate arbitrage cargo flow from the estern market to the western market, andvice versa. Influenced by a couple of various factors, the relative supply-demand balance status for the two regions vibrates from you-strong-I-weak to you-weak-I-strong, leading to the price differential between the two crude oils taking on interval fluctuation. The cross regional arbitrage trading behaviors are just like variation featured by fundamental side re-balancing between the regions, which becomes the cohesive force boosting price change linkage. The global main benchmark crude oils just achieve the price change linkage through cross regional arbitrage trading triggered by cross regional price differential.

    2. Cross regional arbitrage anchoring of the most traded SC crude oil futures contract

    The price anchoring mechanism of cross regional arbitrage is not only applicable to Brent and WTI, Brent and Dubai, but also applicable to Shanghai crude oil futures which newly joined in international oil market system. The supply-demand balance in each region of the world , and Shanghai crude oil futures’s geopolitical characteristics and deliverable crude oil variety design result in that the prices of the most traded SC crude contract are anchored by the spot trade of deliverable oil varieties (Sulfur-bearing medium crude oil in the Middle East, seen in form 1) through cross regional arbitrage.

    The international crude oil futures contracts are listed for trading by the delivery month and listed for the period of a specific month. Commonly, the contract which have the best liquidity with maximum trading volume are called major contracts (the most traded contract). In the WTI, Brent and Oman crude oil futures markets, the major contracts are all first line contracts. For example, the first line contract month of WTI crude oil futures traded in the first half of March is April, while in the case of Brent crude oil futures, the first line contract is for May delivery, and also May for Oman crude oil futures. Every day, the settlement prices of first line crude oil futures contracts are widely reported by news agencies and media, becoming the international oil prices well known to the public.

    Of the three major crude oil futures, considering distance, the physical cargoes corresponding to WTI and Brent crude oil futures to be shipped to China take much longer distance than Oman crude oil futures to be implemented of spot commodity delivery. From the perspectives of oil qualities, the qualities of WTI, Brent and Oman crude oil differ dramatically. Therefore, for the purpose of cross regional arbitrage, obviously, there is no need to seek longer distance instead of shorter to calculate Shanghai crude oil futures prices in association with those of WTI and Brent. Oman crude oil is one of the tradable oil varieties for Shanghai crude oil futures, which is the oil variety for easiest and most directly calculating anchoring prices for cross regional arbitrage. Oman crude oil has its own futures trading on the Dubai Mercantile Exchange (DME). In terms of Oman crude oil futures, the trading is transparent and public which enables spot commodity delivery for obtaining standardized Oman crude oil, meaning that any industrial client who can participate in futures trading is able to acquire physical Oman crude oil with relatively low threshold. Apart from that, the other tradable varieties of Shanghai crude oil futures include Dubai, UpperZakum, BasrahLight crude oil etc., all of which have higher spot commodity operation threshold and more complicated pricing mechanism (the fluctuation in the form of premium and agio). Therefore, the most direct and rapid cross regional arbitrage channel can be built at the initial stage with reference to Oman crude oil.

    2.1 The determination of major contract months

    The domestic futures contracts differ from those of international major futures in major contract distribution. The major contracts of international influential futures are usually near-month contracts, which are also continual. Due to trading habits or some historical reasons, a large proportion of domestic major contracts among futures contracts are distributed in January, May and September. Shanghai crude oil futures is the first to have its futures contracts open to overseas investors, employing continual contract design matching with international custom. It is reportedly known that many domestic and international industrial clients show great interest in taking part in Shanghai crude oil futures trading. Since officially listed on March 26, 2018 a number of crude oil industrial clients have participated in the trading. So it is estimated that the major contract distribution of Shanghai crude oil futures is likely to be just like copper futures that have matched with international futures, taking on the characteristics of continual distribution. However, what is different from international crude oil futures is that the major contracts of Shanghai crude oil futures are not first line contracts. If Shanghai crude oil futures are already in the status of normal operation, by rules, the first line contract month of Shanghai crude oil futures corresponding to the same issue trading taking place in the first half of March is April. For the sake of the deliverable oil varieties designed in Shanghai crude oil futures contracts being overseas resources in majority, which mainly include Dubai and Oman sulfur-bearing medium crude oil in the Middle East, the arrival time for the May Oman crude oil shipped to China is probably June, it can’t be conducted of spot commodity delivery until July when cargoes have been put in the depots and depot lists have been produced. Therefore, the first line contracts of Shanghai crude oil futures can’t realize synchronization with those of Oman crude oil futures in the area of arbitrage relationship, which means that the major contracts of Shanghai crude oil futures are very difficult to be positioned at first line contracts at the initial stage or even relatively long period in the future. If positioned by Oman crude oil futures, the July contracts of Shanghai crude oil futures have very good arbitrage relationship with May contracts of Oman crude oil futures. So, denote the current month as month M, the first line contract month for Brent and Oman crude oil futures is M+2 which is also major contract month in the meanwhile, then the first line contract month for Shanghai crude oil futures contracts is M+1 while the major contract month will probably land in the M+4 month. 

    As for the average clients and participants with no spot commodity delivery intention, the major contract months are of best value in trading participation. Price calculation can be carried out and evaluated in real time. The main cost involved in the process from loading cargoes in Oman ports down to the domestic delivery depots include FOB of Oman crude oil (The first line futures crude oil price of DME Oman crude oil+ spot commodity delivery fee), shipping cost (based on VLCC large tanker), cargo insurance cost, shipping wastage (Insurance companies offer a 0.5% exemption rate), port unloading cost, delivery cost (inspection fee plus poundage), storage quota loss (0.06%), delivery depot storage fee.

    (1) FOB cost. Because of calculation based on real-time tracking, the quote of Oman crude oil doesn’t need to be queried from spot physical markets, just paying attention to the first line quote of DME Oman trading window. Because the minor contract trading time for Oman crude oil (4:00-4:30 PM Beijing Time is trading time for major contracts) is of bad trading liquidity, leading to wide price spread between buying and selling (the price for buying an item and the price for selling it). Apparently, it is possibly inappropriate to make a placement with an intermediate price, furthermore, Shanghai crude oil futures market has closed during this trading period. Therefore, we need more professional information to determine Oman price. However, for rough assessment, we can calculate the price differential between DME Oman crude oil and ICE Brent crude oil (ICE will release a one-minute Brent crude oil price at 4:30 PM Beijing Time) based on DME Oman crude oil first line settlement price acquired at PM 4:30, then based on varying Brent crude oil futures price, we can estimate DME Oman price through using the newest Brent crude oil futures price deducted by the price differential at PM 4:30. The physical cargo delivery cost can be determined via broker companies of foreign markets, the cost mainly having issuance fee, delivery fee, futures trading fee or brokerage charge in embodiment.

    (2) Shipping cost. Firstly, the loading conditions in the Middle East region are basically good in comparison, with each oil variety being able to be loaded on VLCC large oil tanker, therefore taking tanker type into consideration for the calculation of transportation fee, we recommend using VLCC large oil tanker. The flat rate from cargo loading in Oman to unloading at each delivery depot can be obtained through tanker broker or calculation institute. This flat rate is updated once a year. For example, the rate from loading in Oman to Zhanjiang unloading is $12.85 /mt, and $15.96 /mt for to Dalian. Secondly, it is the World Scale (WS) that we shall pay attention to. As you shall inform the tanker company commonly 20 days in advance if you want to rent a tanker in the Middle East, so the world scale at the current period doesn’t represent the actual tanker world scale for claiming the oil in the month M+2, with a certain amount of error and pre-judgement risk. Nevertheless, the overall situation for the current tanker market is that supply is more than demand, with little fluctuation in tanker rates.

    (3) Cargo insurance and exemption rate for shortage in weight.

    Generally speaking, seaborne goods are equipped with insurance. You can look up the quote list offered by the insurance companies to get the insurance rate (especially amid tight tension, warfare additional insurance is rather high), the common exemption rate of  shortage in weight for insurance companies is 5‰. That is to say from the time when cargoes are loaded and bill of lading is issued till cargo arrival and unloading, the insurance company is only obliged for the part which is over 5‰ of the cargo to be compensated. Therefore, the 5‰ exemption rate can be viewed as the upper limit. It shall be clarified that whether the insurance company adopts the vetting data of unloading cargoes or tank data, or else the exemption rate could be increased to 1%.

    (4) Unloading cost

    The unloading cost in each port is made up of many details, such as unloading reception fee, port miscellaneous fee, port building fee, oil mess fee, security protection fee etc. Commonly, the clients prefer to select reception and unloading lump sum fee to sign a contract stipulating overall cost. As far as the current situation is concerned, there exists cost differential in reception and unloading in different places, with the cost ranging from CNY25-35/mt.

    (5) Delivery cost

    It is mainly composed of cost of warehousing formalities, laboratory examination fee and storage cost. The cost of warehousing formalities is paid to the energy trading center with the standard at CNY0.05/bbl. The laboratory examination fee accords with inspection agency standards with the reference price at CNY0.04/bbl. Presently, China Inspection and Certification Group Inspection Co., Ltd., SGS, Shanghai Dongfang Tianxiang Inspection Service Co., Ltd., Technical Center for inspection of industrial products and raw materials under Shanghai Entry-Exit Inspection and Quarantine Bureau, have been validated to be inspection institutions engaged in crude oil futures bonded delivery business. The upper limit for storage charge is set to be CNY0.2/bbl.day.

    (6)  Warehousing quota wastage

    Shanghai crude oil futures trading rules have set the depot’s quota wastage as 0.12%, with the seller and buyer bearing 0.06% respectively. 

    2.2 The major contracts functioning under the mechanism of cross regional arbitrage, achieving the reasonable fluctuation of cross regional price differential.

    The important functions of cross regional arbitrage is to achieve linkage between two regions in crude oil prices. From the perspectives of arbitrage, if Oman crude oil futures price plus transportation miscellaneous cost in the month M+2 (arrival at port and be input to the tanks) is lower than that of Shanghai crude oil futures in the month M+4, we can achieve arbitrage through buying Oman crude oil futures and selling INE crude oil futures. The feedback caused by arbitrage trading will bring the higher Shanghai crude oil futures price down to the normal fluctuation range. Conversely, if Shanghai crude oil futures price in the month M+4 is lower than Oman crude oil futures CIF in the month M+2, then the refineries in China, even in parts of Asia-Pacific region, can buy Shanghai crude oil futures to replace the crude oil with the same quality purchased from Oman in the Middle East. Therefore, just in terms of Oman crude oil anchoring model, the first line contract prices are supposed to fluctuate around Oman CIF. Although there will surely be other participants in Shanghai crude oil futures market, for instance, chemical industry capital, financial capital etc., these participants from different industries will exert a certain extent of impact on Shanghai crude oil futures prices according to their individual comprehension on the market. Relatively speaking, clients in the crude oil industry are at an ascendant position in the market’s game playing to some extent. On one hand, it is because that clients from the crude oil industry can comprehensively employ delivery approaches, arbitrage strategies of futures and spot commodity trading to eventually bring the deviated prices to the normal cross regional arbitrage price range, which is just what the participants from the other industries are lack of. On the other hand, based on the actual situation in China, the concentration degree of crude oil industry clients is comparatively higher than that of chemical industry, therefore more mature in reining over the industry. It is estimated that Shanghai crude oil futures prices run mainly with reference to cross regional arbitrage mechanism models and the arbitrage window may possibly be open for a long time.

    In addition, based on the fact that the Middle East is oil producing region and China is oil importing region, those two regions belong to complementary balance relationship. It is more reasonable that Shanghai crude oil futures price is higher than Oman CIF, otherwise, the supply sides will not be positive. Nevertheless, due to the constantly changing global markets, the players in the western region are always desirous of the resources in the eastern region, therefore, arbitrage competition perpetually exists, resulting that the price differential between Brent crude oil and Dubai crude oil, that between WTI crude oil and Dubai crude oil impose influence on Shanghai crude oil futures major contract prices running relatively higher. Comparatively lower running originates from demand disturbance from its own region, which on one hand comes from operation restarting of refineries, on the other hand comes from depot reserve fluctuation for trading. So, increasing the regional crude oil repository reserves is in favor of the demand sides countering against the brunt from the supply side, avoiding lavish fluctuation in oil price. However, the inventory cost will be eventually paid by the market. Currently, the national oil reserve scale is of some distance from enough, so the inventory capacity of delivery depots can be increased. The business spot commodity inventory capacity formed against the backdrop of Shanghai crude oil futures will inevitably play roles in modifying local short-term supply and demand balance.

    3. The impact made by delivery depots and Basrah light crude on Shanghai crude oil futures pricing

    The Asia-Pacific region and the Middle East region are of complementary balance mutually. Under such mode, if you can’t precisely estimate the demand disturbance scale of your own region, the lower limit price of major contracts seems to quite difficult to break, for the rigid demand enables so. As long as the price is lower, the buyer can make purchase to wait for delivery. Influenced by the delivery depot distribution and oil quality premium setting, the lower limit price of Shanghai crude oil futures cross regional arbitrage anchoring determination is not very clear.

    Firstly, different from American WTI delivery depots concentrating in the Cushing area, the delivery depots of Shanghai crude oil futures are rather scattered. Presently, Shanghai Energy Trading Center has released 6 prescribed delivery depots for crude oil futures, distributed coastal areas from Dalian in the north down the way to Zhanjiang in the south, including 8 depots distributed respectively in Dalian from Liaoning, Dongjiakou from Qingdao, Shandong, Rizhao from Shandong, Daxie from Ningbo, Zhejiang, Zhoushan from Zhejiang, Yangshan port from Shanghai, Zhanjiang from Guangdong, with verified depot capacity totaling 5.95 million cubic meters, launching depot capacity of 3.15 million cubic meters. In addition, 3 standby delivery depots of crude oil futures respectively from Dalian Port Co, Yingkou Port Fairman Island wharf Co., Ltd., CNOOC Yantai Port Petrochemical Warehousing Co., Ltd. have been officially validated while American WTI delivery depots mainly concentrate in the Cushing area, where there are many connected oil pipelines, capable of transporting the crude oil to the major oil refining areas fast through the pipelines. Presently, Shanghai crude oil futures delivery depots are basically connected to limited refineries. As for the purchasers, if they decide to make the delivery while unable to be satisfied in the depot location for commodity delivery, they will set aside more price space in arbitrage calculation. From the perspectives of being cautious, the purchasers are supposed to set a lower limit with reference to the price differential between Shanghai crude oil futures major contract price and the calculated Oman crude oil CIF cost price, and estimate the needed cost of transporting the delivered crude oil to the designated spot commodity depots against the scenario of the possible worst situation. Only when the price differential is more than the needed cost mentioned above, there is enough price security margin and purchasers’ definite arbitrage impulse. If the domestic clients proceed to conduct a second transportation after they are done with delivery at depots and customs declaration, they need to rent domestic tankers, belonging to marine transportation for domestic trades. Reportedly, the domestic trade tanker transportation fee level for the route of Zhanjiang to Huangdao, Shandong is CNY120 /mt ($2.6/bbl), in the meanwhile, the purchasers have to bear various charges including delivery of cargo from storage and oil loading etc., which are all needed to be listed when doing calculation.

    In addition, we should pay attention to the diversity of delivered oil varieties, for there is always existing the effect of “Bad Money Drives Good Money out of Circulation”. Of the four types of crude oil for Beihai BFOE, Forties is of the most inferior quality, so Brent crude oil spot commodities set specific prices basically according to the market price of Forties crude oil. Currently, of the six delivery oil varieties of Shanghai crude oil futures from overseas, the premium for Yemen Marsilla crude oil is +CNY5/bbl, the Basra light crude oil from Iraq stipulates the premium of -CNY5/bbl. Marsilla crude oil resource is comparatively less and the social situation of Yemen is shaky and unstable, so it is not the key target for consideration in the short run. Obviously, the Basra light crude oil should be placed more emphasis. Because the Basra light crude oil is apparently worse than Abu Zakum crude oil from Oman in oil quality, it should be combined with agio when set as delivery oil variety, so the Basra light crude oil is more likely to be the “Bad Money” amidst Shanghai crude oil futures delivery oil varieties.

Generally speaking, there are two sales approaches among the oil production countries in the Middle East. One is long-term contract, the other is spot commodity. For the long-term contract price, the national oil companies issue crude oil valuation formula for the next month every month. In April, 2015, Iraq altered the classification of its produced oil from one variety to two, one of which is the original Basra light crude oil, the other is Basra heavy crude oil. Iraq follows Saudi Arabia in crude oil pricing, particularly the premium trend in its official Basra light crude oil valuation formula taking on strong correlation with that of Saudi Arabia medium crude oil. Due to the fact that the benchmark crude oil in the official Basra light crude oil valuation formula employs the monthly average price of Platts Dubai crude oil and Oman crude oil, the premium of the official price reflects the price differential between the oil variety and the benchmark crude oils in the Middle East, which are Dubai crude oil and Oman crude oil. In the light of official price trend, the price differentials between Basra light crude oil and Dubai crude oil, Basra light crude oil and Oman crude oil have been being widened since January, 2015, leading to obvious shrinkage in the price advantage of Basra light crude oil. Considering Iraq has adjustment in the actual delivered crude oil prices based on API degree (Assume API degree is 34, then the price will be $0.4/bbl off when API degree is brought down 1 unit), it is more probable for Basra light crude oil to become the worst quality delivery oil variety. If the current the API degree for actually delivered Basra light crude oil is 29, it means that the FOB of the Basra light crude oil is $2/bbl lower than the official price. Compared with Oman crude oil, the threshold for obtaining the Basra light crude oil is much higher, so the national oil companies commonly won’t sell the crude oil of long-term contract to the clients without the refinery background, substantially restraining the freedom degree of access to the resources. As for the industry clients, it increases the reserves of deliverable oil varieties.

    It needs noting that the industry clients also run a certain degree of risks to take Basra light crude oil as the delivery crude oil. The main risks lie in that the issuance time of Basra light crude oil official price doesn’t accord with spot commodity trading time window of Dubai and Oman crude oil in the Middle East. Oman crude oil futures in the Middle East employs M+2 system, while Dubai window trading also employs M+2 system, but Basra light crude oil official price issuance takes M+1 system, which means that in the month M, we don’t know about the agio of Basra light crude oil to be delivered in the month M+2. As for clients who are not bonded with long-term contracts, if they go to the spot commodity markets to purchase the Basra light crude oil (Iraq permits resale of crude oil within a pricing range), with spot commodity premium on the basis of the official price, it makes it more difficult to confirm the precise premium of Basra light crude oil against Dubai crude oil and Oman crude oil. The whole official price system of crude oil in the Middle East is relatively complicated, at the same time, the national oil companies won’t completely make public their official price setting models, hence introducing Basra light crude oil as delivery oil variety increases the complexity of anchoring calculation of Shanghai crude oil futures cross regional arbitrage.

    Although cross regional arbitrage anchoring is definite in principles, the setting of delivery depots and the diversity of oil varieties will surely bring about the fluctuation of price differentials. Referring to the volatility of cross regional price differentials between WTI and Brent crude oil, Brent and Dubai crude oil, we can find that over the past five years, the price differential fluctuation between Brent and WTI crude oil has been huge and drastic, additionally, the price differentials between Brent and Dubai crude oil, Brent and Oman crude oil have range bound within the range of $0-5/bbl. It is just because of the existing cross regional price differential volatility that cross regional arbitrage trades are promoted, achieving the price linkage of global benchmark crude oils. The key part is that the implementation of such arbitrage trading is free from the restrictions of undue import policies, unreasonable logistic conditions and oil variety requirements. Under the price anchoring mechanism for cross regional arbitrage, the normal fluctuation is enough to make Shanghai crude oil futures produce strong price correlation with international crude oil futures.

    In conclusion, whether the major contracts will realize price linkage and corresponding changes with the international crude oil futures in the foreign markets under the cross regional arbitrage mechanism is significant foundation for Shanghai crude oil futures to become the regional benchmark crude oil. From geopolitical perspectives, the being listed of Shanghai crude oil futures and forging the role of benchmark crude oil within China, even in the Asia-Pacific region make up for the missing part in the global oil pricing system. Only when Shanghai crude oil futures owns the position of benchmark crude oil, it can play the function as the price barometer and further extend to the financial attribute.