China’s two-pronged strategy for meeting its giant oil-consumption needs involves seeking oil-producing countries as long-term strategic partners while simultaneously attempting to play an important role in the global oil market. China recognizes that the international economy is greatly impacted by the US dollar being the only currency for oil price quotes. This has been observed especially in light of the way in which the US dollar has been gradually devalued during the sub-prime mortgage crisis. The oil price hike has brought tremendous pressure on China to appreciate its currency, the RMB. As a result, China is currently striving to establish a forward market for crude oil so as to secure domestic resource supplies even while counteracting the expansion of US influence into Asia, thus bringing the country to play a larger role in the world oil market. The following translation is of an article on Xinhua News, February 24, 2008, entitled “Some Thoughts on China’s Strategic Financial Planning with Regard to the Petroleum Market.” [1]
Oil prices twice exceeded $100 per barrel within the last week. In addition to the supply and demand for petroleum and international political factors, the devaluation of the US dollar and fund speculation certainly have played a crucial role in the rise of the price of oil. The oil market is becoming an increasingly important aspect in finance. As a giant consumer of oil, China must fully exploit financial strategies to counter the fluctuation of oil prices as an important aspect of its strategic planning for energy and resources.
Negative Effects of the “Oil and Dollar” Duet
The US reached an agreement with OPEC in the 1970s; namely, the US dollar would be the only currency for oil price quotes. Since then, the petroleum market has been intimately tied to the fluctuation of the US dollar. Suffice it to say, with the ups and downs in the price of oil, the variety of incidents which suddenly emerged [recently] have merely been superficial triggers while it is the decisions made by the US Federal Reserve (the Fed) that are the “main switch” ultimately determining the direction of oil price.
Since the sub-prime mortgage crisis, the Fed lowered interest rates three times–on September 18, October 31 and December 11 of last year. As a result, international oil prices rose immediately each time. On the same day that the interest rate was lowered, the forward price of light crude oil increased $0.94, $4.15 and $2.16, respectively, from the price quoted on the previous transaction day. The first two rate cuts resulted in record high crude oil prices at $81.51 per barrel and $94.53 per barrel, respectively, on the same day that the rate cut was announced.
The devaluation of the US dollar keeps pushing up the price of oil. The exchange rate between US dollars and 14 other major currencies all dropped during the last year. For example, the exchange rate with the Euro dropped by about 10.5%, and with the Japanese Yen it dropped by about 6%. Studies show that when the US dollar devalues by 1%, the prices for energy and crude materials rise on an equivalent scale. Currently, if converted to Euros, oil priced at $100 is equivalent to last year’s price at $60.
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At the same time the depreciation of the US dollar has made oil and gold more attractive to speculators. According to experts, speculation has resulted in at least a $25 increase in oil prices. The forward business of West Texas Intermediate (WTI) has increased 18% annually since the beginning of this century. The forward business was expected to have reached 1,300,000 transactions per day, amounting to 1.3 billion barrels per day, which is 15 times the daily consumption of the whole world. At the end of last year, hedge funds invested in the petroleum market had reached $200 billion, a 60% increase from the beginning of last year.
In the face of the US dollar’s devaluation and increasing oil prices the US only needs to increase its export capacity to counteract the negative effects on the US economy. Other countries such as the European Union, Japan and the UK, are able to exchange their currencies with the US freely; they can easily handle the increased oil price by appreciation of their respective currency. However, as China’s currency cannot be traded with US dollars freely as of now, we have to endure the dual pressure from both the increase in oil cost and the appreciation of the Chinese RMB. As a giant consumer of oil, it is a hard reality for us to swallow.
Financial Strategies Need to Be Exploited to Counter Oil Price Fluctuations
The price quote for oil sold to Europe from the Middle East is currently tied to Brent Oil forward pricing; oil sold to the US is tied to WTI forward pricing and oil sold to Asia is priced with reference to Platt’s Oil Price Index. The Platt’s Oil Price Index is based on the evaluation of spot market trading status, which can be easily manipulated. According to statistics, light oil from Saudi Arabia sold to northeastern Asia is usually higher by $1 per barrel than the same oil sold to Europe, and higher by $3 per barrel than oil sold to the US. This single item costs us $0.5 billion to $1.5 billion in oil import expenditures every year. The core issue in strategic oil planning for a nation lies in whether or not the pricing of petroleum is reasonable and can be stabilized within a certain range. In order to change the aforementioned negative effects, China proposed the first draft of the Energy Act at the end of 2007, stating that “the government will establish a mechanism for energy pricing with market regulation being the dominating force.”
Then, how do we arrive at a “market price” for oil imported to China? The answer is, establishing a rational financial strategy for petroleum and encouraging more enterprises to get into the international oil financial market, getting actively involved in an attempt to quote oil price in RMB and gradually establishing an oil business forward market, so as to counteract the inflated oil price. Among all these strategies, establishment of an oil forward market would be our final choice. In order to change the current status wherein the price we pay for oil is higher than what Europe and the US pay, we need to develop a crude oil forward market, so that we have the right to participate in price quoting for crude oil.
After the refined oil is priced on an open (freely-traded) domestic market, the refined oil forward market will also need to be established to set the oil price. In addition, the huge petroleum reserve accumulated by the business transactions of the Petroleum Exchange will also serve to replenish the petroleum reserve in our country.
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Nonetheless, we will have to face a lot of issues during the establishment of a crude oil forward market. Japan, India and other Asian countries have expedited the formation of these forward markets, trying to be key members in the control of oil pricing in the Asia-Pacific region. Some European countries and the US also hurriedly expanded their force into Asia-Pacific, attempting to strangle the formation of an independent oil pricing control system within the Asia-Pacific region. Inside China, many oil-related companies cannot participate in the import trade of crude oil, yet they are not motivated to join the establishment of the forward market. In addition, as to whether we should continue to quote prices in US dollars in order for us to have a certain degree of international influence or to quote prices in RMB for the sake of a long-term, stable development, we do not have a final answer yet.
Presently with the financial system in the process of globalization and the international currency system constantly changing and adjusting itself, some oil supplying countries have started to request that buyers close transactions with currencies other than the US dollar. We have started to see the emergence of “oil price in the Euro” and “oil price in Japanese Yen.” The oil pricing system and currencies used in oil transactions are becoming more diversified. Many oil-supplying countries are willing to accept RMB in trade for oil. In the face of an oil price increase pressuring China to appreciate the value of our RMB, it is a good choice to gradually attempt to quote oil prices in RMB.
China’s investment fund has not yet made its way into the international oil market. A few giant oil companies, after government ratification, will be able to enter the outside forward market to secure the long-term price of oil; however, because doing so will get too much international attention and because there is a lack of a related mechanism inside China, we will be placed in a very passive position. In addition, China does not yet have a hedge fund. So, speculation funds cannot enter into an international petroleum forward market for the time being. These are undoubtedly negative factors for China’s economy. With the development of a domestic forward market, the growth of investment funds, and the opening up of financial business, we should soon move investment funds into the international petroleum market, so as to make a profit from the big fluctuations in the price of oil.
Endnotes:
[1] Xinhua, February 24, 2008
http://news.xinhuanet.com/newscenter/2008-02/24/content_7660540.htm