China’s New Crude Oil Futures Contract to Kick Out the US Dollar

The dominance of the US dollar is over.

The greenback has fallen 6.2% against the Aussie dollar this year. And even though Japan has continued to print money all year to keep the Japanese yen weak, the US dollar is down 3.1% over the same period.

It’s worse when you compare the US dollar to the euro and the British pound, down 11.11% and 10.18% respectively in the year to date.

However, the year of persistent weakness for the greenback is unlikely to end anytime soon.

In fact, if rumours are to be believed, the almighty US dollar is about to lose its powerhouse status.

There’s a saying in markets: Buy the rumour…sell the news.

China has been making plans to rid itself of the US dollar. And it appears no one has been listening.

The greenback’s ‘petrodollar’ status — established in the 1970s — was essentially an agreement between the US and Saudi Arabia. The petrodollar was a contract to price crude oil in US dollars, with the Saudis reinvesting dollars received into US Treasuries.

In doing so, the petrodollar forced all countries around the world to buy and hold US dollars.

But China is done with holding what they perceive to be worthless US currency. And over the next few months, the Middle Kingdom is taking steps to end their reliance on the greenback. If this project gets off the ground, you can guarantee the US dollar is going to tank even further.

China has plans to launch its own crude oil futures contract. It’d be priced in yuan but, and this is very important, the futures contract would be entirely redeemable for gold.

The goal for China is to have this new yuan oil futures become the Asian benchmark, and ideally the most important Asian crude oil price in the world.

At present, the major global benchmarks are the Brent crude price — which is considered the ‘global’ price of oil.

West Texas Intermediate (WTI) crude is considered lighter and sweeter than Brent. The WTI is generally treated as the US benchmark price of oil, and trades a few dollars cheaper then Brent.

Exactly what benchmark China decides to go with is unknown. However, Reuters reports that the majority of crude sold in China is priced against the Dubai, Oman and Brent crude benchmarks.

The Nikkei Asian Review noted two weeks ago that the Shanghai International Energy Exchange is already training and testing the new system:

The Shanghai International Energy Exchange has started to train potential users and is carrying out systems tests following substantial preparations in June and July. This will be China’s first commodities futures contract open to foreign companies such as investment funds, trading houses and petroleum companies.

China has long wanted to reduce the dominance of the US dollar in the commodities markets. Yuan-denominated gold futures have been traded on the Shanghai Gold Exchange since April 2016, and the exchange is planning to launch the product in Budapest later this year.

Markets shouldn’t underestimate the importance of this. What China is proposing will be a game-changer for crude oil markets. And potentially, in the long term, an end to the US dollar as the epicentre of the international fiat currency system.

Even though the yuan was officially included in the International Monetary Fund’s (IMF) special drawing rights (SDRs) basket in October last year, it’s a highly illiquid currency by global standards.

Knowing that illiquidity of the yuan will be a sticking point for oil-producing nations, China will back the contracts with gold. In other words, the Middle Kingdom will allow each country to swap one precious resource for another.

In addition, offering a yuan-denominated contract backed by gold allows oil exporters like Russia, Iran, Qatar and even Venezuela to get around the US dollar by trading in yuan and gold.

Perhaps more importantly, it places a limit on the effectiveness any US imposed sanctions would have. If oil-exporting countries trade with yuan-denominated contracts, it removes the US’ ability to use their currency as soft weapon to force the oil-producing nations into doing what the US wants.

What China’s move means for other countries

The move leaves China in a very powerful position as to who they will do business with.

Take Saudi Arabia for example.

The Arabic kingdom and the US dollar created the petrodollar to benefit themselves. It’s highly unlikely that Saudi Arabia is willing to risk upsetting the US. Even though the Saudis’ share of total exports of oil to China has fallen from 25% in 2008 to 15% in 2016, China is Saudi Arabia’s biggest customer.

China’s move to yuan-denominated contracts is likely to pressure the Saudis to drop US dollar crude contracts. If they don’t, the Saudis may risk losing a major customer. Based on the chart below, if Saudi Arabia doesn’t play along, there’s every chance China could just go elsewhere for the crude:

Chinese crude oil imports 19-9-17

Source: Nikkei Asia Review
[Click to enlarge]

As at the end of 2016, China was importing around 7.6 million barrels of crude per day. At a price of US$50 (AU$62) per barrel, that’s US$138 billion (AU$173 billion) per year.

Given that China is willing to swap gold for oil, based on a gold spot price of US$1,321 (AU$1,657), that’s roughly 31 tonnes of gold per year.

The chart clearly shows just how diverse Chinese crude imports are. Between Russia, Brazil and Venezuela, the Middle Kingdom imports around 25% of crude.

However, if countries like Iran, Iraq and even Saudi Arabia agree to a yuan- or gold-supported oil futures contract, that means 50% of China’s crude oil imports could potentially be paid in currencies other than the US dollar.

There’s no hard date for when the yuan crude oil contract will begin. But this move alone would have crippling effects on the US dollar.

The decline of the US is set to continue. And China plans to kick it while it’s down.

Kind regards,

Shae Russell,
Editor, Markets & Money

PS: Crisis & Opportunity editor Greg Canavan believes the oil market is getting ready to stage a rally. In fact, he says that Saudi Arabia’s planned initial public offering for the state-owned Saudi Aramco — which could raise as much as US$100 billion — is a bullish signal for the price of oil. The way Greg sees it, now is the time to enter into energy stocks that will rally as the Saudis start selling off parts the company. Click here to learn more.

Shae Russell started out in financial markets more than a decade ago. Working with a derivative brokering firm, she helped clients understand derivative markets, as well as teaching them the basics of technical analysis. Since joining Port Phillip Publishing eight years ago, Shae has worked across a number of publications. She holds the record for the highest-returning stock recommendation, in which a microcap stock returned over 1,200% in six months. Ask her about it, and she won’t stop yapping on. For the past two years, Shae has worked alongside Jim Rickards as his Australian analyst, translating global macro trends for Aussie investors, and how they can take advantage of these trends. Drawing on her extensive experience, Shae is the lead editor of Markets & Money. Each day, Shae looks at broad macro trends developing around the world, combining them with her distaste for central banks and irrational love of all things bullion.

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