On September 1, 2017, the Nikkei Asian
Review published an article titled, “China
sees new world order with oil benchmark backed by gold”, written by Damon Evans. Just below the
headline in the introduction it states, “China is expected shortly to
launch a crude oil futures contract priced in yuan and convertible into gold
in what analysts say could be a game-changer for the industry”. Not long
after the Nikkei piece was released ‘the story’ was widely copied in
sensational analyses throughout the gold space. However, ‘the story’, as
presented by Nikkei, doesn’t make sense at all. Allow me to share my 2 cents in
addition to what I shared previously on the Daily Coin.
All the rumours and analyses on gold, oil and yuan that are making rounds
now in the blogosphere are based on the Nikkei article. But the Nikkei
article itself contains zero official sources. Basically, the whole story has
been invented by Damon Evans. So, let’s start addressing the claims made in
the Nikkei piece.
It’s true that the Shanghai Futures
Exchange (SHFE) – not to be confused with the Shanghai Gold Exchange (SGE) – has recently
set up a subsidiary called the Shanghai
International Energy Exchange (INE), for foreign enterprises to trade a
new oil futures contract denominated in yuan which is expected to be launched
later this year (product symbol: SC). Specifications of the contract can
be read here.
In all official sources, though, there is no mention of gold. Officially this
contract is not “convertible into gold”.
The only vague connection I could find is that the INE “will accept
foreign exchange as … trading margin”. If this includes gold – which
technically is not foreign exchange – we will see. In any case, even if gold
will be used as trading margin that doesn’t mean the contract is “backed
by gold”.
The Nikkei headline clearly reads “China sees new world order with
oil benchmark backed by gold”. In this
context, the word “backed” for most readers will refer to a fixed
parity. In the past, for example, there was a fixed parity between gold and
the US dollar; this meant the dollar was backed by gold through the US
Treasury; dollars could be redeemed for gold at a fixed price and vice versa.
In case of the Nikkei story it would imply a fixed parity between yuan, or
oil (this is not clear), and gold. But how would China back anything with
gold? Would China’s central bank (the PBOC) defend a fixed price of gold in
yuan? And it would do so through an oil futures contract? Impossible.
Quickly ‘the story’ by Nikkei transformed through the blogosphere where
analysts suggested the gold in SGE vaults would back the yuan. The problem
with this theory is that gold in SGE vaults, (i) isn’t owned by the Chinese
government, and (ii) isn’t allowed to be exported from the Chinese domestic
market (not very convenient for foreign oil producers). Then analysts
suggested the gold in vaults of the Shanghai International Gold Exchange
(SGEI) would do the job. But SGEI gold, (i) isn’t owned by the Chinese
government either, and (ii) can only have been sourced in the international
gold market, payed for with US dollars. So much for the oil-gold trade
circumventing US dollars as presented by Nikkei.
Now, let’s zoom in on the logic behind the phrase “crude oil futures
contract priced in yuan and convertible into gold”. Futures
contracts are an agreement between two traders about the future price of
i.e. a commodity (usually denominated in a currency, in the case of the INE
contract yuan). There can be no third asset, commodity or currency involved
in a futures contract. It cannot be that upon physical delivery of SC – when
oil is exchanged for yuan – one of the two traders will say, “you know what,
I don’t want yuan (or oil), I want gold”. And, needless to say, the Chinese
government will not mingle in the futures trade. The PBOC will not jump in
when a SC short or long demands gold. Again, the new INE oil futures contract
denominated in yuan will have nothing to do with gold.
What is possible is that when a SC short delivers oil in exchange for
yuan, he is then free to buy gold with the proceeds. One can do so directly
on the SGEI where
three physical gold products denominated in yuan are listed.
Though, be reminded, currently no oil producer is prohibited from buying
gold (or something else for that matter) when paid in US dollars. That’s
actually the very function of money. Money is used, since ancient times, for
what is called indirect
exchange. Stuff is sold for money, and with that money all other
stuff can be bought. Gold can be bought with the proceeds from oil sales
since … forever. An oil futures contract will not suddenly change all that.
In the Nikkei piece one analysts was quoted saying:
It’s a transfer of holding their assets in black liquid to yellow metal.
It’s a strategic move swapping oil for gold, rather than for U.S. Treasuries,
which can be printed out of thin air.
But oil producers are free to buy gold with their moneys (yuan or dollars)
with or without the new futures contract. The INE contract will not remove an
obligation i.e. for Kuwait to invest in U.S. Treasuries. So, what will change
when this new oil-yuan futures contract is launched?
Also bear in mind that futures are hardly ever physically delivered.
Futures are used for hedging and speculation. In general, commodities are
physically traded in the spot market. Oil for dollars, chocolate for Swiss
francs, Dutch cheese for euros, etcetera. Futures contracts are not
necessarily needed to sell oil for yuan. Nikkei wrote:
China’s move will allow exporters such as Russia and Iran to circumvent
U.S. sanctions by trading in yuan.
But effectively, Venezuela, Russia and Iran can sell their oil to China in
exchange for yuan as of this very moment, before the oil-yuan futures
contract is live. They also could have done so three years ago. So, in my
very humble opinion the new INE contract will not be the instant game changer
everybody is talking about.
Perhaps also noteworthy, one commentator on the Nikkei story wrote:
China just announced that any oil-exporter that accepts yuan for oil can
convert the oil to gold on the Shanghai Gold Exchange and hedge the hard
currency value of the gold on the Shanghai Futures Exchange.
My comments on this paragraph:
- As shown above China hasn’t announced anything but an
oil-yuan futures contract. Gold has nothing to do with it.
- Yuan can technically be spend on gold at the SGE, but
gold in the Chinese domestic market (SGE system) is not allowed to be
exported. Gold from the SGEI is allowed to be exported but is bought in
the international market via yuan with US dollars.
- Foreign enterprises, like oil producers, cannot hedge
gold on the Shanghai Futures Exchange. The SHFE is not open for
international customers. There’s only a spot deferred product
listed on the SGE, which is comparable to a futures contract, through
which foreign enterprises can hedge gold in yuan. But why would oil
producers buy gold and subsequently hedge the metal in yuan. Their end
position would be merely exposure to the price of yuan. Why then, not
buy a yuan denominated bond with an interest rate? Or hold gold without
the hedge?
Prior to publication of the Nikkei article in question I got an email from
Evans. He asked me if “China will tie a gold guarantee to the new oil
contract?”. I replied, “No. I would be surprised if they did that”.
But my quote wasn’t selected for the final publication. The piece only quoted
analysts singing the same song. In my view, that’s not what sound journalism
is about. First of all Evans didn’t use any official sources, and second he
picked analysts that confirmed his bias.
Aside from all the inaccuracies in the Nikkei article, what stands out for
me is that indeed a large number of countries is willing to trade oil in yuan
and the new INE futures contract is important for this development as it
allows oil producers and users to hedge directly in renminbi. And so the INE
contract will support oil for yuan trading. That’s what the article should
have focussed on.
Although not much has happened yet*, it’s clear Asia wants to
get rid of the petrodollar, and it will be interesting to see how this
initiative develops.
*Still the majority of global trade is conducted in US dollars, and most
foreign exchange reserves are in dollars too. The share of
yuan payments, compared to all other currencies, tracked by
payment service provider SWIFT were
under 2 % in June, down slightly from two years ago. (I have no
data on CIPS payments.)
And even China has added over
$107 billion in U.S. Treasuries since November 2016.
If you would like to learn more about the Chinese gold
market and the SGE(I), please read my recently updated Chinese
Gold Market Essentials Guide.
