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China’s crude oil futures， traded on the Shanghai International Energy Exchange （INE）， is the first futures contract in the country to allow international investor participation.
Even before its launch on March 26， 2018， there was much suspicion about whether the INE crude oil futures might be successful. All these doubts and concerns were completely understandable， given the serious challenges encountered in the past in other Asian countries， not to mention the INE’s deviation from all predecessors in having the contract denominated in the yuan.
But now， at the time of its three-year anniversary， we can congratulate it on finding its feet and achieving preliminary success as a regional benchmark. What are the factors that might have contributed to the success？ And what challenges may lie ahead？
In March 2018， when Bloomberg asked me to comment on the operation of China’s crude oil futures， based on its first-day performance in comparison with other crude oil futures in Asia， I said， “Based on the trading volume on the first day， Shanghai’s crude oil futures contract seems to be ready to be influential in the region.”
In a surprise to many， even myself to some extent， this indeed has quickly become true. China’s crude oil futures have witnessed very rapid growth in both trading volume and particularly open interest over the last three years.
The average daily trading volume reached a historical high of 171，135 contracts in 2020， compared with 141，985 in 2019 and 140，261 in 2018. Even more impressively， the average daily open interest of the INE crude oil futures in 2020 reached an all-time high of 118，909 contracts， a 312-percent increase compared with 28，796 contracts in 2019. The number was 19，808 contracts in 2018.
The dramatic increase in the open interest during 2020 sent a credible signal of improving market quality， as it primarily reflected more involvement of hedgers with legitimate ties to the real economy. This is hugely important， given the well-known problem of short-term speculation dominating many futures markets in the country.
This led to a very substantial decrease of the speculation ratio from 7.7 on average for the first active contract in 2018 down to 2.65 on average in 2020. By comparison， the ratio is typically around 1 or 2 for the most active contract of West Texas Intermediate （WTI） and Brent oil futures， two major international crude oil futures benchmarks. Foreign investors have played a very important role in the market. Their trading volume increased continuously， from 7.46 percent in 2018， to 15.22 percent in 2019， and to 18.65 percent in 2020. Their open interest share also increased from 14.2 percent in 2018 to 21.68 percent in 2019， and to 24.97 percent in 2020.
Since 2020， there has been far more active participation of foreign investors than what is suggested by the percentage point increase， as the average daily open interest in 2020 has quadrupled， compared with 2019.
Much progress has also been made in building up the term structure of crude oil futures prices， which is particularly important for serving the real economy. Back in 2018， about 95 percent of trading was concentrated on only one contract， with the maturity in a particular month.
Now， there is typically substantial （around 50 percent） trading volume and open interest on contracts with maturities in other months， other than the most active contract. This again signals a more healthy market.
The COVID-19 outbreak clearly gave an unexpected boost to its growth. Nevertheless， the relatively successful development of China’s crude oil futures thus far is probably not
accidental for the following reasons： First， the market has been successful in establishing important links with existing international benchmarks since its inception. Research published in Journal of Futures Markets， a leading journal in this field， has shown that the first active contract of China’s crude oil futures traded during March to September 2018 had much stronger linkages with the existing global benchmarks（i.e.， WTI and Brent futures） than the Oman crude oil futures in the Middle East， a previous No.3 crude oil futures market.
Second， analysis shows that among its seven deliverable grades of crude oil， China’s crude oil futures already maintained a stable long-term relationship with the spot prices of all six grades imported to China （from Dubai， Abu Dhabi， Oman， Yemen， Iraq and Qatar） before the pandemic era.
The evidence sheds more light on the international price discovery performance of China’s crude oil futures， helping explain why foreign investors increased their participation during 2020.
Third， unlike some other futures markets in China dominated by speculation， the crude oil futures has significantly reacted to the industry fundamentals since its inception， with the exception of the pandemic era. The WTI crude oil inventory data released weekly by the U.S. Energy Information Administration is widely considered to be an important piece of industry information. Even during its first active contract in 2018， the magnitude and the length of the response of China’s crude oil futures to the WTI crude oil inventory news was on average comparable to the WTI futures， and even surpassed the Brent futures.
Fourth， the warehouse delivery mechanism of China’s crude oil futures is unique and has multiple locations. Standing in sharp contrast with the delivery to a hub required by the Brent and particularly by the WTI， the INE has delivery warehousing in geographically dispersed eight warehouses in port cities.
All these features turned out to be helpful in dealing with the risk of delivery disruption due to COVID-19. The warehousing storage capacity was substantially increased in 2020， which is now largely comparable to the WTI’s.
Lastly， the liquidity of the market has improved dramatically. In 2020， there was a dramatic reduction of extreme illiquidity， often existing during the last month before the expiration. For the most active contract， the average market liquidity of China’s oil futures， as measured by the bid-ask spread， is now comparable to and is only slightly lower than the Brent oil futures in London.
However， there will be some challenges ahead on the future growth path for China’s oil futures. For example， its trading volume and open interest can’t still be compared with WTI and Brent’s. China’s oil futures are still largely a price follower rather than a price leader on the international markets. The entrenched use of the U.S. dollar in the global oil trading is another big hurdle that China’s yuan-denominated oil futures needs to navigate.
But despite all the challenges， the potential is considerable. The underlying crude oil grades of the futures cover more than 40 percent of global oil production. It is also in line with the oil produced in the Asia-Pacific region.
Given the increasing influence of the Chinese economy in the world and particularly in Asia， there are good reasons to expect greater development of China’s oil futures. BR
Even before its launch on March 26， 2018， there was much suspicion about whether the INE crude oil futures might be successful. All these doubts and concerns were completely understandable， given the serious challenges encountered in the past in other Asian countries， not to mention the INE’s deviation from all predecessors in having the contract denominated in the yuan.
But now， at the time of its three-year anniversary， we can congratulate it on finding its feet and achieving preliminary success as a regional benchmark. What are the factors that might have contributed to the success？ And what challenges may lie ahead？
Unexpected progress
In March 2018， when Bloomberg asked me to comment on the operation of China’s crude oil futures， based on its first-day performance in comparison with other crude oil futures in Asia， I said， “Based on the trading volume on the first day， Shanghai’s crude oil futures contract seems to be ready to be influential in the region.”
In a surprise to many， even myself to some extent， this indeed has quickly become true. China’s crude oil futures have witnessed very rapid growth in both trading volume and particularly open interest over the last three years.
The average daily trading volume reached a historical high of 171，135 contracts in 2020， compared with 141，985 in 2019 and 140，261 in 2018. Even more impressively， the average daily open interest of the INE crude oil futures in 2020 reached an all-time high of 118，909 contracts， a 312-percent increase compared with 28，796 contracts in 2019. The number was 19，808 contracts in 2018.
The dramatic increase in the open interest during 2020 sent a credible signal of improving market quality， as it primarily reflected more involvement of hedgers with legitimate ties to the real economy. This is hugely important， given the well-known problem of short-term speculation dominating many futures markets in the country.
This led to a very substantial decrease of the speculation ratio from 7.7 on average for the first active contract in 2018 down to 2.65 on average in 2020. By comparison， the ratio is typically around 1 or 2 for the most active contract of West Texas Intermediate （WTI） and Brent oil futures， two major international crude oil futures benchmarks. Foreign investors have played a very important role in the market. Their trading volume increased continuously， from 7.46 percent in 2018， to 15.22 percent in 2019， and to 18.65 percent in 2020. Their open interest share also increased from 14.2 percent in 2018 to 21.68 percent in 2019， and to 24.97 percent in 2020.
Since 2020， there has been far more active participation of foreign investors than what is suggested by the percentage point increase， as the average daily open interest in 2020 has quadrupled， compared with 2019.
Much progress has also been made in building up the term structure of crude oil futures prices， which is particularly important for serving the real economy. Back in 2018， about 95 percent of trading was concentrated on only one contract， with the maturity in a particular month.
Now， there is typically substantial （around 50 percent） trading volume and open interest on contracts with maturities in other months， other than the most active contract. This again signals a more healthy market.
Not accidental
The COVID-19 outbreak clearly gave an unexpected boost to its growth. Nevertheless， the relatively successful development of China’s crude oil futures thus far is probably not
accidental for the following reasons： First， the market has been successful in establishing important links with existing international benchmarks since its inception. Research published in Journal of Futures Markets， a leading journal in this field， has shown that the first active contract of China’s crude oil futures traded during March to September 2018 had much stronger linkages with the existing global benchmarks（i.e.， WTI and Brent futures） than the Oman crude oil futures in the Middle East， a previous No.3 crude oil futures market.
Second， analysis shows that among its seven deliverable grades of crude oil， China’s crude oil futures already maintained a stable long-term relationship with the spot prices of all six grades imported to China （from Dubai， Abu Dhabi， Oman， Yemen， Iraq and Qatar） before the pandemic era.
The evidence sheds more light on the international price discovery performance of China’s crude oil futures， helping explain why foreign investors increased their participation during 2020.
Third， unlike some other futures markets in China dominated by speculation， the crude oil futures has significantly reacted to the industry fundamentals since its inception， with the exception of the pandemic era. The WTI crude oil inventory data released weekly by the U.S. Energy Information Administration is widely considered to be an important piece of industry information. Even during its first active contract in 2018， the magnitude and the length of the response of China’s crude oil futures to the WTI crude oil inventory news was on average comparable to the WTI futures， and even surpassed the Brent futures.
Fourth， the warehouse delivery mechanism of China’s crude oil futures is unique and has multiple locations. Standing in sharp contrast with the delivery to a hub required by the Brent and particularly by the WTI， the INE has delivery warehousing in geographically dispersed eight warehouses in port cities.
All these features turned out to be helpful in dealing with the risk of delivery disruption due to COVID-19. The warehousing storage capacity was substantially increased in 2020， which is now largely comparable to the WTI’s.
Lastly， the liquidity of the market has improved dramatically. In 2020， there was a dramatic reduction of extreme illiquidity， often existing during the last month before the expiration. For the most active contract， the average market liquidity of China’s oil futures， as measured by the bid-ask spread， is now comparable to and is only slightly lower than the Brent oil futures in London.
Remaining challenges
However， there will be some challenges ahead on the future growth path for China’s oil futures. For example， its trading volume and open interest can’t still be compared with WTI and Brent’s. China’s oil futures are still largely a price follower rather than a price leader on the international markets. The entrenched use of the U.S. dollar in the global oil trading is another big hurdle that China’s yuan-denominated oil futures needs to navigate.
But despite all the challenges， the potential is considerable. The underlying crude oil grades of the futures cover more than 40 percent of global oil production. It is also in line with the oil produced in the Asia-Pacific region.
Given the increasing influence of the Chinese economy in the world and particularly in Asia， there are good reasons to expect greater development of China’s oil futures. BR