By Jianjun <http://www.jamestow n.org/china_ brief/analysts. php?authorid= 332>
Tu

In recent years, oil product shortages in China have frequently caught the
attention of the world. In August 2005, China’s southern manufacturing
heartland of Guandong was plagued by closed service stations, fuel rationing
and hours-long gas queues, and authorities were forced to send thousands of
police to petrol stations in Guangzhou to prevent massive social unrest as
drivers scrambled to fill their tanks (Wall Street Journal, August 19,
2005). In May 2006, a diesel shortage hit Guangdong again and lasted for
half a month until a 270,000 ton emergency stock of gasoline and diesel fuel
were allocated to the local market by China National Petroleum Corporation
(CNPC) and China Petroleum and Chemical Corporation (Sinopec) (Xinhua News
Agency, May 23, 2006). Since then, not only has the frequency of oil
shortages increased, but also the geographic coverage of such events,
extending to Beijing, Shanghai, Yunnan, Xian, and Henan (International
Herald Tribune, October 31, 2007; Henan Business Daily, October 30, 2007;
China Daily, March 29). On May 12, a magnitude 8.0-earthquake struck
southwest China with its epicenter at Wenchuan County in Sichuan province.
The death toll so far has exceeded 40,000 with 248,000 injured and 32,000
missing. To speed its unprecedented disaster relief efforts, Beijing had to
drain its strategic oil reserves (Xinhua News Agency, May 20). The
constraint on China’s petroleum infrastructure by the earthquake coupled
with China’s recent stockpiling of diesel fuel ahead of the 2008 Beijing
Olympics Games have unsurprisingly raised anxiety about the stability of the
international oil market (Wall Street Journal, May 19).

After China replaced Japan as the world’s second-largest oil-consuming
nation in 2002, major Chinese national oil companies have not only
strengthened their domestic dominance but also successfully expanded their
international presence. After CNPC, China’s largest oil producer, returned
to the Shanghai A-share stock market in November 2007, PetroChina, the
listed arm of CNPC, edged ExxonMobil and was ranked first amongst the
world’s top 50 energy companies (Reuters, January 23). Similarly, China’s
posted crude oil distillation capacity overtook Russia as the world’s
second-largest in 2006, and Sinopec is currently the world’s third-largest
oil refiner in terms of production capacity [1]. Even China National
Offshore Oil Corporation (CNOOC), the smallest of China’s three oil majors,
almost doubled its annual petroleum production between 2000 and 2007,
ranking seventh on Forbes’ “Asia’s Fabulous 50 Companies” list in terms of
market value [2]. Moreover, spikes in oil prices in recent years have
stimulated a worldwide investment frenzy in the petroleum industry; crude
oil supply and refining capacity have generally balanced the growth in
demand well in the world market. Given the strong performance of major
Chinese national oil companies, the sufficient oil supply in the
international market, China’s chronic oil shortage raises a legitimate
question: what is wrong with China’s oil industry?

Driving Force Underlying China’s Chronic Oil Shortage

When oil shortages make headlines, price regulation by the Chinese central
government has usually been identified as the primary underlying driving
force. Before Deng Xiaoping opened China to the outside world in 1979, the
Chinese economy was largely centrally controlled and planned in one-, five-
and occasionally ten- and twelve-year time horizons. Since then, the once
tightly controlled energy sector is now much more decentralized and
market-oriented. When China’s current pricing framework for crude oil and
oil products was first introduced in 1998, it was intended to allow the
prices of both crude oil and oil products to track international
fluctuation. The aim was to progressively remove the government from the
pricing process, to integrate China’s oil markets with international
markets, to provide clear commercial incentives for oil companies and to
send correct signals to consumers [3]. The outcome so far, however, is far
from encouraging. In order to maintain the incentive for exploration and
production of oil within China and import crude from the international
market, domestic crude oil prices have been allowed to follow international
levels. In comparison, after the 1998 reform, pricing policy for oil
products has been further changed. In November 2001, the powerful National
Development and Reform Commission (NDRC) set the price of processed oil
based on the average price of oil products in the Singapore, Rotterdam and
New York markets, and the government will only adjust the price of oil
products once the international price rises above an eight percent threshold
(Xinhua New Agency, October 31, 2007). Yet the relatively free market
approach soon started to crumble as crude oil prices rose above $40 per
barrel in 2004. To protect consumers from high energy prices and retard
surging inflation pressure-which is an increasing headache for China’s
decision makers because of its serious impact on social stability-NDRC has
constantly maintained domestic oil product prices significantly lower than
international levels in recent years.

Historically, Beijing always needed to subsidize at least one of its
national oil companies when oil prices were tightly regulated. As CNPC,
Sinopec and CNOOC had focused mainly on onshore oil and gas exploration and
production; downstream activities such as refining and distribution; and
offshore petroleum exploration and production, respectively, none of these
companies had the ability to subsidize price regulation related financial
losses with profits from other parts of its business operations. In 1998,
when Beijing reorganized most state-owned oil and gas assets and made CNPC
and Sinopec into two vertically integrated firms, one objective of
restructuring these companies was to reduce the heavy financial burden of
subsidy by the government. As a result of the 1998 restructuring, the
rationale of NDRC’s oil product price control may seem reasonable-the
current financial losses incurred in the downstream refining operations of
the CNPC and Sinopec could be covered by the windfall profits from each
company’s upstream production. In reality, however, behavior of the major
players in China’s oil industry did not meet Beijing’s expectations. While
China’s national oil companies did not hesitate to stifle domestic
competition from their non-state rivals, these publicly traded monopolies
are still inclined to observe the corporate economic bottom line of profit
maximization whenever possible. Both CNPC and Sinopec were reportedly
unwilling to fully utilize their refining capacity to meet domestic demand
when oil product prices were not high enough to cover their production
costs, and they have allegedly manipulated oil shortage events through
product stockpiling, shutting down refinery capacity and increasing export
of oil products (Sohu.com, August 16, 2005; Xinhua News Agency August, 13,
2007).

Moreover, all Chinese national oil companies-including CNOOC, a new entrant
to China’s downstream industry-have managed to delay the construction
progress of either their Greenfield refinery addition or Brownfield capacity
expansion in recent years [4]. To make the situation worse, oil imports by
Guangdong, the province hardest hit by oil shortage, decreased 18 percent in
2007 on a year over year basis, and oil exports from Guangdong increased
sharply by 47 percent during the same period (Xinhua News Agency, March 24).
Facing enormous political pressure, Sinopec eventually cut its oil exports
and stepped up production to supply the market in May 2006, and CNPC quickly
followed suit and shipped more oil from its northeastern refineries to South
China with the intention to break into Sinopec’s turf (Xinhua News Agency,
May 17, 2006). Yet the Chinese government’s application of soft pressure
toward major national oil companies has failed to solve the chronic oil
shortage across China, as there exist other important factors in the market
that are far more difficult to control by government regulations.

Distortions in China’s Oil Industry

Unlike China’s mismanaged coal mining industry-which was historically
plagued by as many as 100,000 small township and village enterprises in
1991, a low technological level and appalling safety record [5]-China’s oil
industry has many fewer players. This is especially evident in the upstream
exploration and production part of the industry, which is still cornered by
CNPC, Sinopec and CNOOC. Nevertheless, after nearly three decades of
economic reform, Chinese private enterprises have made inroads into the oil
industry in downstream activities such as oil refining and distribution.
International oil companies also have a modest presence in China,
particularly in offshore exploration and production.

There are three types of petroleum refineries in China. The first is
state-owned refineries including joint ventures with foreign companies.
Currently, Sinopec runs about 26 refineries with an annual crude capacity of
160 million tons per annum (Mt/annum). In comparison, CNPC operates about 24
refineries with a crude capacity of 120 Mt/annum. The capacity of West
Pacific Petrochemical Corp.-Dalian, the first joint venture refinery in
China, is 10 Mt/annum [6]. The second type is local and private refineries
(LPRs). As early as 2005, the aggregate crude capacity of Chinese LPRs
reached 80 Mt/annum. The crude capacity in Shangdong, Guangdong and Shaanxi
alone exceed 45, 15, and 10 Mt/annum, respectively (Economic Information
Daily, March 31; International Financial Daily, September 19, 2005). Access
to refinery feedstocks is currently the most pressing issue for Chinese
LPRs. For instance, local refineries in Shangdong have only been assigned
1.69 Mt/annum of the crude oil quota by the central government, and only
processed 7.2 Mt of crude oil and 16 Mt of heavy fuel oil (HFO) in 2007, or
a 52 percent capacity utilization rate (China Stock Network, April 28;
Economic Information Daily, March 31). The third type is numerous illegal
teapot refineries, which often process either crude stolen from state oil
companies or heavily polluting feedstocks such as recycled fuel oil or waste
tires. By the end of 2000, China had reportedly closed more than 6,000 such
facilities, but how many teapot refineries are still illegally operating
remains an open question [7].

To meet its surging oil demand, China plans to add more than 90 Mt/annum
crude refining capacity during the 11th five-year planning period
(2005-2010), which will be primarily fulfilled by investment from either
national oil companies or joint ventures with international majors [8].
While the Chinese government keeps shutting down illegal teapot refineries
due to their notorious environmental and safety records, Beijing’s attitude
toward LPRs is also quite hostile. Before 1998, there were about 193 local
refineries in China. In May 1999, Beijing ordered the closure of most local
refineries, and only allowed 82 to remain operating, which includes 19
belonging to CNPC and Sinopec [9]. In the wake of the oil price spike in the
early 2000s, the once profitable petroleum refining sector suffered
ever-increasing deficits due to price regulation on oil products, so both
CNPC and Sinopec were able to close their inefficient small refineries in
early 2000s. Yet unlike developed countries such as the United States,
Beijing has not developed a fair revenue sharing framework between the
central and local governments. Local governments generally benefit much less
from national oil companies than from local enterprises. As a result, many
LPRs that were ordered for closure have managed to survive under the
protection of local authorities. Nevertheless, these survivors and new
refinery entrants often need to hide the nature of their business with
misleading names such as “asphalt plant” (Liqing Chang), “solvent
manufacturer” (Rongji Chang) and “lubricant company” (Runhuayou Gongsi).

The uncertain legal status of LPRs has seriously distorted the statistical
reporting of China’s oil industry. While crude distillation capacity of
Chinese LPRs has exceeded 100 Mt/annum, only one such facility-Yanan
Refinery at Luochuan-was covered by Oil & Gas Journal’s annual worldwide
refinery survey so far [10]. Even Chinese statistical agencies were unable
to provide accurate data regarding these facilities, so the actual capacity
of China’s petroleum refining industry has been constantly underreported in
recent years. Moreover, Chinese LPRs not only are currently unable to secure
sufficient crude oil supply from domestic upstream producers, but also are
not allowed to freely import crude oil from the international market. While
HFO is not subject to Beijing’s import restrictions, most Chinese LPRs are
forced to process imported straight-run fuel oil. As a result, China’s HFO
imports grew quickly by 64 percent since 2002, reaching 31.4 Mt in 2006
[11]. Under the tightly controlled Chinese oil market, LPRs’ relentless
request to secure their feedstock supply has presented some unique
challenges to regulators as a significant portion of feedstock processed by
LPRs came from several “underground” channels. First, LPR operations have
stimulated oil-related criminal activities. For instance, more than 1 Mt of
crude oil stolen from the Shengli oilfield is sold to adjacent refineries
annually. Second, importing crude oil as HFO has become popular amongst
LPRs. It is estimated that more than 10 Mt of crude oil is imported into the
Chinese market through this channel each year. Third, the crude oil quota
may be obtained from national oil companies by paying premium and bribe
[12].

Unlike their state-owned rivals who have a political obligation to meet
domestic demand, Chinese LPRs operate according to market rules. When the
price of oil products is deemed too low, LPRs could entirely shut down their
refining operations. As the coordination between national oil companies and
LPRs is poor, the operation strategy of LPRs would add complexity into
national oil companies’ efforts to stabilize the market. Moreover, in
China’s National Energy Balance Tables, HFO credited to LPRs as refining
feedstock has been mistakenly allocated as energy consumption by the
industrial sector. The aforementioned statistical distortion coupled with
the fact that part of China’s transport fuels have already been misreported
under other end-use sectors make the forecast of China’s oil demand a much
more difficult challenge than it otherwise should be. When this researcher
modeled China’s energy and environmental trajectory between 2005 and 2050 to
provide input to the G8 Gleneagles dialogue on climate change mitigation in
2008, he needed to reallocate 95 percent of gasoline and 35 percent of
diesel in China’s industrial, construction and service sectors, 100 percent
of gasoline and 95 percent of diesel in the residential sector, and 100
percent of gasoline in the agricultural sector back as transport fuels to
correct the statistical distortion [13].

Similar to oil shortages, oil smuggling is another chronic pain haunting
China’s energy sector. In the 1990s, when prices of oil products in China
were maintained artificially high in favor of domestic refiners, smuggling
diesel into China was rampant. After the Xiamen Yuanhua Smuggling Case was
uncovered, 40 Mt of diesel was reportedly illegally shipped into one Chinese
port alone between 1994 and 1998 (Hong Kong Commercial Daily, September 13,
2000). Since then, unofficial oil imports are still thought to have been as
high as 20 Mt/annum in the early 2000s [14]. In recent years, smuggling oil
products out of China has rebounded strongly due to NDRC’s price regulation
on oil products. To counter the rampant oil smuggling, Beijing has an urgent
need to eliminate the very incentives it has created. While the current
price regulation on oil products has effectively lowered refinery capacity
utilization of Chinese LPRs, before Beijing corrects such price distortion,
it needs to proactively solve the crude oil supply issue haunting Chinese
LPRs. Otherwise, a strong incentive will be created to stimulate smuggling
crude oil into the domestic market, with a detrimental impact on China’s
national energy statistical accounting.

Beijing’s price control of oil product is the primary driver underlying
recent oil shortages, and the hostile regulatory environment imposed on LPRs
has certainly compounded the situation. Chinese decision makers have long
wished to reign in the chaotic oil industry in an environment of falling
energy prices, but increasingly elevated oil prices in recent years suggest
that Beijing may need to correct the very price distortion it has created
even when oil prices are still high. Otherwise, the misleading price signals
will undoubtedly compromise China’s energy conservation efforts. Moreover,
with Chinese LPRs’ relentless quest to justify their existence with large
scale expansion [15], Beijing can no longer run an energy policy that is so
hostile toward its private oil enterprises. As the stakes involved are high,
both the enormous investment made by the private sector and the relationship
between central and local governments should be carefully taken into
calculation. Ideally, Beijing could create a fair regulatory environment
under which long-anticipated healthy competition could be introduced amongst
players in China’s oil industry; otherwise, a prolonged chaos in this
strategically important sector may undermine the great economic achievement
of the past three decades.

Notes

1. U.S. Energy Information Administration; Oil & Gas Journal
2. CNOOC Annual Report, various years; Fobes Special Report: Asia’s Fab 50
Companies, September 06, 2007.
3. Philip Andrews-Speed on April 09, 2008, China: Oil prices, subsidies and
rebates – where do we go from here? Available at
http://www.dundee. ac.uk/cepmlp/ gateway/index. php?news= 29168.
4. Personal communication with various anonymous industrial contacts in
China; U.S. Energy Information Administration, World Crude Oil Distillation
Capacity, January 1, 1970 – January 1, 2008.
5. JianJun Tu (2007). Coal Mining Safety: China’s Achilles’ Heel. China
Security: vol. 3(2), p. 36-53
6. Sinopec and CNPC corporate websites; Oil & Gas Journal; First Financial
Daily, May 12, 2008, available at
http://news2. eastmoney. com/080512, 835814.html.
7. State Economic and Trade Commission, available at
http://www.js. cei.gov.cn/ zhjj/text/ express/LAA/ LAA82803. TXT.
8. State Council (2005). Medium- and Long-term Development Plan of Petroleum
Refining Industry, available at
http://gys.ndrc. gov.cn/gyfz/ t20060316_ 63179.htm.
9. State Council (1999). Opinions regarding Regulating Small Refineries,
Crude Oil and Refined Products Markets, available at
http://www.china5e. com/laws/ index2.htm? id=200503220007.
10. 21st Century Economic Report, April 5, 2007; Oil & Gas Journal.
11. National Bureau of Statistics and Energy Bureau (2007). China Energy
Statistical Yearbook 2007.
12. Wang Zhi (2005). Explore the Underground Operation Chain of Small
Refineries in Shangdong. Chinese Entrepreneurs: vol. 2005(6).

 

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