On Monday, China launched its first ever Yuan denominated oil futures contract.
In case you are not familiar with oil futures, they are contracts that agree the price of oil today to be delivered at a later date. They are usually used to hedge against higher oil prices in the future.
The futures are open to foreigners. As Reuters reports, Glencore and Trafigura were some of the first to take part in the yuan denominated futures.
China is a heavyweight when it comes to oil demand. It already has some influence in global oil prices.
In 2017, China surpassed the US to become the world’s biggest oil importer. The country is also the world’s second largest oil consumer.
The new futures will give China more pricing power.
China is also looking to challenge the two current benchmarks with the new future. For one, there is the Brent crude, which trades in London. The second is the West Texas Intermediate (WTI), which trades in New York.
The new yuan denominated oil future could become a third benchmark with influence in the Asian region.
Chinese Yuan challenges the US dollar
China is also looking to promote the Yuan around the world to become more prominent in international trade…and to challenge the US dollar.
This is a very big deal.
Especially as it is coming at a time when there are increasing tensions between the US and China on trade.
In recent years, China has become one of the largest importers of commodities in the world.
Having commodities priced in yuan gives China more pricing power. But, it also gives the country more influence on exporting countries that depend on commodity exports.
In a way, that’s how the US dollar became dominant.
In 1973, the US negotiated a secret deal with Saudi Arabia. In exchange for pricing oil in US dollars, the US would provide military protection.
Since most of the world bought oil from Saudi Arabia at that time, it led to a major demand for US dollars. That was the beginning of the Petrodollar.
By 1975, all the OPEC countries had agreed to price their oil only in US dollars.
Since then, the global oil trade is mostly conducted in US dollars.
Any country that wants to buy oil needs to exchange their currency for US dollars first. This makes the US dollar the world’s currency for commodities, in particular oil.
And it strengthened the dollar by increasing its demand around the world.
The thing is, pricing oil in yuan could be only the beginning for China in their quest to sideline the US dollar.
China’s making allies to take down the US dollar
The Asian giant is becoming a heavy weight in the commodities sector, and also increasing its influence. Recently, China has been striking deals with commodity exporting countries in exchange for funding and infrastructure.
Venezuela for example, has borrowed around US$50 billion from China, in exchange for cheaper oil.
Brazilian semi-public oil firm Petrobras, agreed in 2016 to a US$10 billion financing deal from the China Development Bank Corp for oil. Ecuador’s state owned Petroecuador has also arranged similar deals.
Guinea has recently borrowed US$20 billion for infrastructure. In exchange, China gets concessions on bauxite and aluminium ore.
With these deals, the Chinese reduce the risk of default, but it also gives the country an assured long-term energy supply.
China has also been increasing economic ties with different countries through the One Belt One Road initiative. The project seeks to revive the old silk route and bring Europe, Asia, Africa and Oceania closer.
Pricing commodities in yuan also gives countries facing US sanctions a way to accept other currencies for oil. And some are starting to take part.
Iran started accepting yuan for oil payments back in 2012…China is a big buyer of Iranian crude oil.
Some Russian oil producers are already starting to accept Chinese currency in exchange for oil.
And this is also a big deal. Think about it, two of the world’s big energy giants — China and Russia — can now bypass the US dollar when trading oil.
If more countries stop using the US Dollar for these agreements, it could have a huge effect on the demand of the US dollar. Right now, everyone trading commodities around the world uses dollars, which creates a huge demand for the dollar.
A decrease demand for the dollar will weaken it.
The US dollar Index, which measures the US dollar against a basket of major foreign currencies, has been recently losing ground. Even while the US Federal Reserve has been increasing interest rates…
The graph below shows the US dollar index’s performance over the last year.
[Click to enlarge]
With demand weakening, we could see a long term weaker dollar.
China is slowly shifting attention away from the US dollar. The petrodollar system only works as long as the US dollar maintains its prominence in global trade.
China transferring oil payments from the US dollar to yuan could mean we are witnessing the end of the petrodollar.
Editor, Markets & Money
PS: With a weakening US dollar and tensions increasing between the US and China in trade, it is always a good idea to have some gold in your portfolio. In fact, Crisis & Opportunity editor Greg Canavan thinks gold is about to breakout…big. But, before you go running off to buy some gold, read this first.