China sees new world order with oil benchmark backed by gold

The comment:

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.

The contract could become the most important Asia-based crude oil benchmark, given that China is the world’s biggest oil importer. Crude oil is usually priced in relation to Brent or West Texas Intermediate futures, both denominated in U.S. dollars.

China’s move will allow exporters such as Russia and Iran to circumvent U.S. sanctions by trading in yuan. To further entice trade, China says the yuan will be fully convertible into gold on exchanges in Shanghai and Hong Kong.

“The rules of the global oil game may begin to change enormously,” said Luke Gromen, founder of U.S.-based macroeconomic research company FFTT.

The Shanghai International Energy Exchange has started to train potential users and is carrying out systems tests following substantial preparations in June and July. This will be China’s first commodities futures contract open to foreign companies such as investment funds, trading houses and petroleum companies.                           …….

The existence of yuan-backed oil and gold futures means that users will have the option of being paid in physical gold, said Alasdair Macleod, head of research at Goldmoney, a gold-based financial services company based in Toronto. “It is a mechanism which is likely to appeal to oil producers that prefer to avoid using dollars, and are not ready to accept that being paid in yuan for oil sales to China is a good idea either,” Macleod said.


The source:

Nikkei Asian Review, 1 September 2017

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My thoughts:

A little history may help explain the significance of China’s move away from the US dollar (with my thanks to Jerry Robinson – ):

  • The petrodollar system originated at the 1944 Bretton Woods conference. After World War II, the United States held most of the world’s supply of gold. It agreed to redeem any US dollars for its value in gold if all other countries pegged their currencies to the dollar. That established the dollar as the world’s reserve currency.
  • In 1945, President Roosevelt formalized an alliance with Saudi Arabia. The United States built an airfield at Dhahran in return for military and business training. The alliance survived differences of opinion over the Arab-Israeli conflict.
  • In 1971, US stagflation prompted the United Kingdom to redeem most of its US dollars for gold. President Nixon took the dollar off the gold standard to protect the remaining gold reserves. As a result, the value of the dollar plummeted.  That hurt the Organization of the Petroleum Exporting Countries (OPEC), because their oil contracts were priced in US dollars. Their oil revenue dropped along with the dollar. The cost of imports, denominated in other currencies, increased.
  • In 1973, a deal was struck between Saudi Arabia and the United States in which every barrel of oil purchased from the Saudis would be denominated in US dollars.  (The US dollars would be recycled back to America through contracts with the US. contractors.) Under this new arrangement, any country that sought to purchase oil from Saudi Arabia would be required to first exchange their own national currency for US dollars. In exchange for Saudi Arabia’s willingness to denominate their oil sales exclusively in US dollars, the United States offered weapons and protection of their oil fields from neighbouring nations, including Israel.
  • By 1975, all of the OPEC nations had agreed to price their own oil supplies exclusively in US dollars in exchange for weapons and military protection.
  • Oil-exporting countries have since become more sophisticated. They now recycle their petrodollars through sovereign wealth funds. They use these funds to invest in non-oil related businesses. The profits from these businesses make them less dependent on oil prices.
  • As the US dollar continued to lose purchasing power, several oil-producing countries began to question the wisdom of accepting increasingly worthless paper currency for their oil supplies. Today, several countries have attempted to move away, or already have moved away, from the petrodollar system. Examples include Iran, Syria, Venezuela, and North Korea (three of whom make the “axis of evil” list).

The US has found itself between a rock and a hard place.  Saudi Arabia is the home of Wahhabism, an ultra-orthodox form of Islam.  ISIS in turn traces its roots back to Wahhabism.  And of course the terrorists involved in 911 were mostly Saudi citizens.  Hence the supreme irony of incoming President Trump visiting Saudi Arabia earlier this year to sign a USD350bn arms deal with the Kingdom – the largest in American history. Yet the US can ill-afford to lose OPEC’s commitment to the US dollar.

China, in turn, holds a lot of US dollars (and US Treasuries) , and would appear intent to convert them for hard assets as fast as possible.  By setting up international trade arrangements that by-pass the US dollar it is seeking to protect its own base while simultaneously and inevitably accelerating the demise of the dollar.  China also finds itself between a rock and a hard place:  US markets have long provided the demand that has enabled China’s economic rise.   Exchange rate movements will effectively choke off that demand, leaving China increasingly reliant on its swelling middle class.  That may not be enough.

Quite the balancing act.