This week marked the launch of oil futures trading at the St. Petersburg International Mercantile Exchange (SPIMEX) – the Kremlin’s first step towards creating an instrument that sets a “fairer price” for Russian crude, according to the company’s top executives.
Up until now Urals were sold outside the exchange, mainly through direct long-term delivery contracts, which meant that the only the participants of these transactions knew the price of the commodity. As a result, it was priced against other benchmarks, usually at a discount to Brent.
“The goal of our project is to establish a market for Russian crude, namely Urals, based on a new price discovery mechanism that is transparent and accepted by the markets. We hope that it will produce a fairer price for Russian crude without any relation to other benchmarks like Brent, UTI or Dubai,” said Mikhail Temnichenko, First Vice President of SPIMEX.
“Our ultimate goal, pending the market’s approval, is to establish a benchmark for international trading on the basis of Russian crude deliveries,” added the VP.
In the past, similar attempts to detach commodities from the Western pricing agents, such as Platts, and set up independent exchanges, have been mostly unsuccessful. OPEC, China, Iran and Venezuela, among others, have attempted to set up oil futures contracts in other currencies, but to no avail.
Moscow itself saw its own rouble-denominated futures trade on the New York Mercantile Exchange in 2006, but the contracts were discontinued six years later because traders showed little interest. Nevertheless, creating instruments that would allow to trade oil and other commodities on Russian exchanges has since remained one of president Putin’s lifelong passions.
“It looks like this may well go ahead given the local support,” noted Julius Walker. “But it’s worth pointing out that there have been various attempts to create crude oil contracts based on Middle Eastern crude, Chinese crude, and in actual fact nothing much has come of those.”
The global oil market is still currently dominated by the I-Sprint and NYMEX WTI futures contracts in London and New York, respectively.
It’s not an insurmountable challenge, some say. China recently managed to break the trend by setting up its own benchmark for coal. But, according to Thomas Pugh, Commodities Economist at Capital Economics, that stems from the specificity of the market and will not necessarily apply to Russia’s current objectives.
“China’s coal benchmark may turn out to be a more successful play because you don’t really have many major benchmarks or contracts in the Asia Pacific region,” Pugh explained. “So there may be room to set up something like that with oil in China. As the country grows, it will become a major consumer, so it could be argued it would have more power to say they want to buy oil in their own currency.”
“With oil, you have Brent in Europe, which Russia would be trying to compete with, and WTI in the US. And with the market oversupplied, it is much more of a buyer’s market than a seller’s market, so it is hard to draw parallels,” he added.
There have been attempts to increase the significance of Urals before, explained Neil Hart, Supply & Trading Director at Smart Global Trading.
“Some entities have looked at trading Urals out of Rotterdam, for example, so we have seen attempts to increase the significant of Urals in the market rather than pricing off Brent.”
But it is also necessary to consider the factors that allowed the Brent benchmark to become so dominant. Crucially, Brent used to price close to the source – and as that source has declined it has been supplemented by other crudes going into the BFOE blend, Hart said.
“Also, it’s relatively transparent, has large number of participants, is freely tradable, and there are no government restrictions around where and how it can be traded. For Russian crude, that is potentially the biggest barrier,” Hart concluded.
On the surface, the biggest drive to create a Russia-centric crude pricing benchmark is Russia’s grudge against Western pricing agencies, exchanges, and clearing houses for rating Russian crude at levels it sees as inherently unjust. But is the country’s concern linked to the added cost paid by the consumer, or is it something more self-interested?
“For Russia, this is all about the tax take,” said Hart. “It’s not so much about the consumer but increasing the government tax take… as a result, getting a transparent free tradable market-grade of Urals as opposed to Brent or Dubai is going to continue to face barriers.”
Another reason, Hart explained, is Russia’s desire to increase its production profile. As the largest country in the world, it traditionally had additional export capacity north into the Baltics and south, beyond the Black Sea. And now, amid the “pivot to the East”, China is providing new export opportunities, so geopolitical considerations are clearly another significant factor for the Kremlin.
“Pipeline politics is always an interesting feature with Russia and rightly so, given their reserves and the significance of Urals. This talk of de-dollarization is important, the Chinese are looking at this as well. Russia launches SPIMEX; Shanghai is already running Shanghai Exchange; watch this space…” Hart noted.
“Part of this is about status and prestige,” agreed Walker. “The Russians have long been peeved that they are still one of the biggest players in global oil yet prices for their oil are determined far away. Putin in particular has often complained that Russian crude doesn’t sell for its full value.”
SPIMEX’s leadership admits that its short-term ambitions are more reserved and realistic. “There are some plans for rouble-denominated contracts, but the initial project involves only dollar-denominated trades,” Timonchenko highlighted.
Even so, Moscow will be facing a gargantuan task. Currently, 75% of the world’s crude is priced on Brent, which is priced in dollars. SPIMEX’s liquidity levels are, for now, effectively negligible and, which creates a chicken-and-egg situation.
“Until you have significant liquidity, a lot of players are reluctant to get on board, and until they get on board you don’t have liquidity,” Walker said. “Numerous futures contracts and similar financial instruments have not taken off because people didn’t buy or trade them.”
The scale gap is perhaps best exemplified by the massive difference in collateral held by Western and Russian clearing houses. Though neither ICE nor CME discloses how much collateral is held against energy trades, their total initial margins are US$87bn and US$142bn respectively – compared to SDCO’s (run by Gazprombank) estimated US$230mn.
Traders who decide to shift to SDCO will have to post far more collateral, especially if SPIMEX were to switch to rouble-denominated futures. The currency risk, analysts observe, would be far too great.
The companies involved in producing or buying Russian crude have an interest in derivatives that allow them to hedge or purchase these sales. Seeing as futures are in themselves an instrument for hedging against risk, there would be little use for traders if they would then need to hedge against the futures.
“If you are a European refinery, you can’t perfectly hedge Urals crude, but you can hedge by using Brent, with no exchange rate risk,” Walker said.
“Given all of the associated extra risks that come with dealing in those currencies, it isn’t clear what the advantage to me as a consumer would be, unless you were guaranteed favourable terms,” Pugh echoed, adding that such terms could create room for the Kremlin to interfere and potentially manipulate pricing, perhaps the biggest obstacle for SPIMEX in the quest to establish a global benchmark.
“Some of the main worries that outside investors and financial players would have when looking at whether to trade these instruments is the degree of government intervention in the broadest terms, and anything that smacks of too much government intervention would make these contracts less attractive,” Walker concluded.
Another issue is logistics: any such crude futures contracts would have to be in some way based on the physical flow and delivery of Russian crude oil.
Here, again, a higher degree of transparency would be required over what influences these exports. The Russian government has a sizeable degree of control over crude export volumes and destinations.
Ultimately, traders may not be tempted to participate in rouble-based oil derivatives trading unless the government acts address their long list of concerns.