China's deregulation, expansion not enough to restore market balance

Haijiang Henry Wang
Energy Security Analysis Inc.
Washington, D.C.

• Southern China's Maoming refinery in Guangdong province is unable to keep up with local products demand despite a massive modernization program. Soaring refining products demand in China's booming southern provinces helps keep a prop under ever-rising products imports.
• Oil Production and Net Exports
• Diesel Production, Consumption, and Net Exports
• The platform shown lies in the offshore portion of Sheng* oil field, China's second biggest producing area. The combination of declining production in Sheng* and refinery expansion in the surrounding Shandong province has resulted in eastern China experiencing the nation's worst crude oil deficit.
• Diesel Oil Imports, Spread

The Chinese oil market surprised the world again in 1996, showing striking signs of a boom year and recovering from its 1994 downturn. But, despite increased production of crude oil and refined products, strong demand has kept fundamentals very tight, resulting in greater oil imports. Although China is instituting a number of policy initatives, its oil market is expected to enjoy only slightly loosened controls. Planned deregulation and increased oil and products output will be inadequate to pull the country out of its oil and product deficits. Last year, China's oil production increased for the first time in 10 years. But production will experience only meager growth in the foreseeable future, while consumption continues to increase. Thus, despite increased oil production, the country's crude deficit will swell. In the products arena, government price controls and a refining industry structure that favors production of gasoline over diesel act in concert to maintain a shortage of diesel fuel in China. In spite of diesel import quotas, supplies will continue to be short unless Singapore diesel prices fall to levels deemed acceptable by Chinese importers.

Policy initiatives

While China's overall oil policy remained essentially stable in 1996, a number of new measures were proposed and adopted. Implementation of these policies is likely to have a far-reaching impact on the Chinese oil market in the future.

China's latest policy initiatives are:

• Import tariff cuts

In 1996, China cut import tariffs on oil products, both as part of its bid for membership in the World Trade Organization and to reduce import costs and bring China's high oil prices in line with the world market. Last November, China reduced its gas oil import tariff to 3% from 6% and its fuel oil tariff to 3% from 12%. Similar cuts in import tariffs on naphtha and gasoline may take effect this year.

This is a further step toward integrating China's oil market into the world market at a time when China is a net importer of oil and refined products. By reducing their costs, Chinese importers will have the added flexibility of purchasing in spot or futures markets or otherwise hedging their positions-choices which are increasingly important, given high world oil prices.

With lower tariffs, China will be a more aggressive buyer in the international oil market. In addition, the import tariff cuts on petroleum products will squeeze the profits of oil smugglers, thereby reducing the amount of oil smuggled into the country.

• Oil pricing system changes

China's tightly regulated oil pricing system is facing direct challenges. First, because domestic crude supply is suffering an increasingly serious shortfall, more major refineries and petrochemical plants will use imported oil in the next few years. It will be difficult for these plants to financially reconcile constantly fluctuating import costs with regulated domestic product prices.

Second, some onshore oil fields that have foreign investments will be allowed to sell crude in the domestic market at international prices in 1997. This will complicate and possibly destabilize the regulatory price structure in China.

Third, China has an urgent need to obtain additional funds (through higher oil prices) to increase exploration in remote western areas.

The government is being pressured to enact price reform. In a segregated oil industry with separate upstream and downstream companies, upstream companies and some refiners who use imported crude have an incentive to push for price deregulation as a means of improving profitability. But other refiners are not in favor of this change because of their inefficient operations. (Deregulated oil prices would subject refiners to margin volatility.)

Nevertheless, the emergence of a new oil pricing system is expected to further open China's oil market and eventually encourage additional foreign investment.

• Joint ventures

In September 1996, a provisional regulation was approved by the state council that allows foreign companies to set up joint trade ventures with Chinese partners in Shanghai's Pudong area and in Shenzhen, both of which are special economic zones (SEZs).

This could be regarded as a preliminary step in breaking the state's monopoly in international trade. With the increasing flow of oil into the domestic market, this policy change is expected to lead to more competition among trading companies and lower prices for Chinese end users.

Japan's Idemitsu, for example, opened a service station in northern China's Dalian area. The station is operated through a joint venture (JV) of Idemitsu and China Oil (a petroleum products trading company), in which Idemitsu holds a 70% interest. China Oil has agreed to supply gasoline to the service station from the Daqing, Dalian, and other domestic refineries.

This partially foreign-owned retail business in SEZs will serve as a test case for Chinese policy-makers in determining whether foreign investors will be permitted to establish a retail network beyond SEZs. To gain entry into this potential market, foreign investors should seek JV opportunities, or those located in SEZs, or both.

• Motor vehicle tax reform

In 1996, Chinese motor vehicle owners were subjected to at least 20 taxes and fees. After a 2-year tax experiment in Hainan province, China has proposed that these multiple taxes and fees be combined into a single fuel-consumption tax. While no specific timetable has been set for its implementation, this proposed tax consolidation will likely stabilize tax rates, making auto ownership increasingly attractive.

The move will enable the government to promote the domestic automotive industry by simplifying the motor vehicle taxation structure while maintaining high gasoline taxes.

Economic growth

For 40 years, China's oil demand has been driven by domestic supply. Although this pattern has changed slightly at times when a surge in petroleum product imports caused the government to temporarily reduce scheduled refinery output, domestic de- mand continues to rely primarily on domestic refinery capacity.

In 1996, refineries processed 3 million b/d of crude (a 120,000 b/d increase from 1995), and total refined product consumption reached 3.3 million b/d (a 190,000 b/d rise). Similar to 1993, 1996 was a high-growth year as the result of a demand surge.

The robust growth of 1996 differs from that of a true boom year such as 1993 in that, in 1993, the oil market enjoyed a short-lived period of freedom-less government restriction of oil prices, retail businesses, domestic exchanges, and international trade.

Strong demand growth in the face of a tight macroeconomic environment, such as occurred last year, indicates steady demand despite greater government control. Current demand may be more sustainable in the long term if regulation loosens somewhat.

Will the strong demand of 1996 force China to again tighten its policy in 1997? ESAI does not believe so.

There have been significant changes in China's macroeconomic environment during 1993-96. In 1993, inflation skyrocketed, and the economy was overheated by excessive investment and a large domestic money supply. But inflation is now under control, and the economy appears to be more stable.

China's economy and oil market each continue to follow a boom-bust cycle, but their cycles are not necessarily concurrent. As long as the government is not struggling with an overheated economy while fighting inflation (or sliding into a bust cycle), the bullish oil market will last.

In fact, the fate of China's oil market is strongly influenced by macroeconomic policy. Inflation's negative effect on social stability remains a primary concern of the government. A tight economic policy to curb soaring inflation would also control expansion in the oil market.

Although China is still suffering year-on-year losses from state-owned enterprises, the impetus of economic growth has steadily shifted to the private sector.

The good news for the oil industry is that China's economy landed softly in 1996. Inflation is falling toward 10% (or lower) from 25% in 1994, and growth in gross domestic product is about 10%.

China's target for 1997 is to keep inflation at 10%. If macroeconomic pressures were eased, however, tight control of the oil market might be relaxed somewhat.

Historically, oil statistics have tended to quickly reflect any shift in regulation, so a loosening could lead to sustained demand growth. While economic growth expected to be 8-9% this year, ESAI anticipates that total oil demand in China will continue its fast-track growth, increasing by another 200,000 b/d.

Oil production

For the first time in 10 years, China's oil production rose 150,000 b/d, or 5%, in 1996. This robust growth did not result from any fundamental change in production capacity but was driven by a 1-year jump in offshore output. While offshore production was surprisingly high, the growth is expected to last for only a year or two.

China's offshore production is dominated by China National Offshore Oil Corp. (Cnooc). Cnooc's output rose from next to nothing in early 1990 to 300,000 b/d in 1996, accounting for more than 9% of total domestic production that year.

Surprisingly, 1996 offshore production was about 75% more than 1995 levels and made the largest contribution to increased 1996 oil output. This growth is unsustainable over the long run, however, due to limited proven reserves and restricted exploration and development (E&D) funding.

Most of the increase in offshore production came from operations in the South China Sea. In 1996, the eastern area of the South China Sea produced 200,000 b/d of crude, or two thirds of total offshore production. The South China Sea was the first offshore area opened to foreign oil companies for E&D.

China's crude supply policy-"stabilizing the east, developing the west"-seems to work well in the east but has thus far shown few signs of success in the west.

The three largest oil producing areas in the east had mixed results in 1996: Daqing maintained output, while Shengli's production fell, and Liaohe production rose somewhat. Daqing-China's largest producing complex-continued to produce 1.1 million b/d, or 35% of the national total in 1996.

In recent years, new technology that uses polymers to extract oil helped Daqing produce an additional 20,000 b/d and stabilized the field's output. During the next 5 years, China is scheduled to introduce tertiary recovery in its major eastern oil fields by applying polymer flooding and alkaline-surfactant polymer flooding.

The techniques are expected to increase production 140,000-200,000 b/d by 2000, partially offsetting the decline in other eastern oil fields. China hopes to maintain Daqing production at 1 million b/d until 2010-5 years beyond its previous estimate.

The Xinjiang Uygur autonomous region in northwest China (which includes the Tarim basin) produced about 340,000 b/d of oil in 1996. The region's proven reserves also increased.

The Tarim basin, a major focus of China's E&D activities, produced 60,000 b/d in 1996 compared with 51,000 b/d in 1995. This is an increase of about 20%.

China National Petroleum Corp. (CNPC), the state-owned onshore firm, expects Tarim crude output to reach 90,000 b/d in 1997-an increase of 50% from 1996.

Outlook

According to former CNPC Pres. Wang Tao, China has a potential oil resource of 680 billion bbl, including 460 billion bbl onshore and 220 billion bbl offshore. But original oil in place (OOIP) totals 130 billion bbl-less than 20% of potential oil resources (of that total, 92% of OOIP is onshore and 8% is offshore). Two-thirds of OOIP cannot be extracted, however, leaving China 20 billion bbl of proven reserves and a reserves-to-production ratio of 17 years.

China's oil experts have forecast an additional 4-5% increase in crude production for 1997. The oil fields in the northwest (such as Tarim, Turpan-Hami, and Xinjiang) are expected to contribute another 40,000 b/d, offshore oil development will add 100,000 b/d, and eastern fields will maintain current production levels.

Wang Tao also declared that onshore crude output is expected to increase 20,000-40,000 b/d during 1996-2000. This small increase indicates that China's oil production will be insufficient to support economic growth.

Offshore oil production is expected to peak at 340,000-380,000 b/d in 2000 based on current estimates of proved reserves. During the next 5 years, growth in crude production will vary widely, with annual growth averaging 2.4% until 2000. Output is projected to reach about 3.4 million b/d by 2000 vs. 3.1 million b/d in 1996.

Annual growth in oil output should slow after 1997, reflecting a mature phase of offshore E&D and premature conditions in the Tarim and Xinjiang basins.

Current government policy requires that CNPC and Cnooc be responsible for their own profits and losses. Crude prices remain regulated, but, because Cnooc is an offshore company, it has full flexibility to sell crude in the world market. In contrast, CNPC has experienced diminished profits as a result of regulated oil prices.

Following the successful experiments in Tarim and Turpan-Hami oil fields, CNPC will be restructured to improve efficiency. The management and budget functions of its exploration and production activities will be separated from those of technical services, logistics, and other non-oil operations. This is one step closer to western corporate strategies and further from Soviet-style management techniques.

Crude balance

Oil production and demand data for 1995 reveal the regional oil balance in China and indicate possible flow among the provinces. China's regional oil dynamics can be characterized as an increasing crude deficit in the east and a growing diesel and fuel oil deficit in the south, primarily in Guangdong province.

The northeast, where Daqing is located, maintained an oil surplus of 700,000 b/d in 1995. These surplus barrels are available for export to Japan and North Korea and for feeding refineries in northern and eastern China.

The two oil-deficient regions are eastern and south-central China. The east includes large consuming cities and provinces such as Shanghai, Jiangsu, and Zhejiang and the second largest oil producer, Shengli, in Shandong province. South-central China includes the economically booming province of Guangdong.

Of these two areas, the crude deficit in eastern China has grown much more rapidly during the past few years. This growth is the result of reduced production from Sheng* and refinery expansion in the region.

In contrast, the oil deficit in the south has remained at about 200,000 b/d since the early l990s. Slow expansion of refining capacity and rapid increases in offshore oil exploration in the region have helped ease the oil demand shortfall.

Xinjiang is the only area that significantly increased its oil surplus in the past 5 years. The volume of crude available to other regions, however, is still relatively small (about 110,000 b/d). Considering growing oil demand in neighboring provinces such as Gansu, total crude availability for the rest of China has been rising slowly.

In the future, regional oil balances will depend much more on refinery expansion and debottlenecking than on changes in oil production. This is because the annual ups and downs of oil production will be marginal, while added refinery capacity in a region will quickly alter the oil balance.

If refinery expansion plans (including the addition of some JV refineries and debottlenecking and revamping of state plants) can be fulfilled in eastern and southern China, the oil deficit in these areas will rise dramatically. For this reason, the world oil industry should keep an eye on these regions.

With rapid growth in crude production, Xinjiang is still primarily self-sufficient. If and when small refineries on the periphery of oil fields in the region achieve their expansion targets, they should absorb the additional barrels being developed in the region. This could further limit Xinjiang's ability to ship more oil to central and southwestern China.

Product balance

As the economy in southern China (particularly Guangdong province) continues its rapid growth, rising shortages of diesel and fuel oil will require increased imports. For other regions, the product market could be generally balanced or moving toward balanced in the coming years.

The three northeastern provinces, which hold 25% of the country's distillation capacity (1.1 million b/d) have the greatest product surplus, while the northern and the south-central provinces have the largest deficit. During the past 5 years, south-central China has had the most dramatic change in its product balance: Its deficit in principal products tripled to more than 150,000 b/d.

The southwest, which includes the most populated province, Sichuan, has relatively low demand but is also short in all products because of limited refinery capacity.

Diesel oil deficits are seen in northern and south-central China, with Beijing and Guangdong both running seriously in the red. Northern China's diesel demand could easily be supplied by the northeast region, but the south and southwest have to rely on diesel imports.

In contrast, gasoline supply and demand are more balanced in the major consuming regions.

In recent years, fuel oil has emerged as a tight product, with a major shortage appearing in Guangdong. While other regions are a bit tight in fuel oil, expansion of oil-fired power plants and industrial boilers in Guangdong will determine how much fuel oil China will import. In 1995, Guangdong, with only 6% of China's population, accounted for 18% of national fuel oil demand.

The diesel deficit

China's demand slate is heavily weighted toward diesel oil. And, for 5 years, diesel has seen greater demand growth than other products. In contrast, diesel supply growth has trailed demand growth for many years due to capacity constraints and inflexible price controls.

China's refining capacity is characterized by a large catalytic cracking capacity (equivalent to about 25% of distillation capacity). This refining structure favors production of gasoline rather than diesel. Furthermore, such a high catalytic cracking ratio will not change easily over the next several years, and this will restrict increases in diesel output.

At present, principal product prices are controlled. Ex-plant gasoline is priced at $32/bbl-$5-6 higher than ex-plant diesel. There is no seasonal adjustment for these prices.

Low diesel prices are designed to stimulate agricultural development, on which China places a high priority. But the gasoline-diesel price differential has only two consequences: it encourages refiners to produce more gasoline at the expense of diesel and causes consumers to use more diesel. These effects increase the diesel deficit.

Any attempt on the part of government to impose refinery production controls in order to reduce the diesel deficit would be unlikely to meet with success. In 1996, Chinese refiners produced 1.17 times more diesel oil than gasoline vs. a diesel-gasoline ratio of about 2.27 for Singaporean refineries. Whenever the market requires more diesel, refiners respond not by reducing gasoline yields, but by increasing throughput. This constrains diesel output.

In a bid to redress the mismatch, in 1996 China increased regulated diesel prices to align more closely with world prices and promote diesel production. But the price adjustment was too small to encourage refiners to increase diesel output much.

In many ways, 1996 was a nightmare year for China's diesel market, which faced one of its most serious shortages ever. Robust economic growth and a loosening of government restrictions stimulated diesel demand growth of 5.6%. And summer flooding increased demand from the transportation and industrial sectors, further increasing diesel demand.

Even with higher domestic diesel prices, the drain in supplies at times made the fuel available only to government-designated end users.

Price differentials

Due to a surge in world diesel prices, China's 1996 diesel imports were less than expected. Despite strong demand, imports fell short of 1995 levels.

Chinese industry experts estimated that more than 80,000 b/d of diesel import quotas went unused during the first half of 1996, when Singapore diesel prices averaged $25.66/bbl-almost $4/bbl higher than the same period in 1995. Correspondingly, China's cost, insurance, and freight price for imported diesel in first-half 1996 also jumped $2.50/bbl from 1995 levels.

After tariffs and taxes, the price of imported diesel oil rose to about $33.90/bbl-$3.20/bbl higher than the domestic ex-plant prices. In the Guangdong province the diesel wholesale price surged as high as $40/bbl. Guangdong imported the most diesel oil. (Most users of imported diesel are Sino-foreign JVs.)

In 1994-95, when Singapore diesel prices were lower than domestic prices, JVs imported diesel to cut fuel costs and generate profits by resale. Now, with high world market prices, there is no incentive for them to do so.

As can be seen, China's diesel imports depend not only on industrial and economic activity, but also on the price differential between the domestic and world markets. If world market prices plus tariffs and taxes are less than controlled prices, demand will encourage imports and smuggling. Otherwise, diesel imports will be sluggish despite strong demand.

Given current domestic prices, imports are feasible only when the Singapore diesel price is less than $23/bbl. Like all refiners, those in China will respond to price signals rather than domestic demand. As a result, imported diesel will take more market share in China when Singapore prices are low.

This situation will not change unless much additional refining capacity comes on stream early next century. In the short term, unless there is a shift in oil policy, the diesel market will remain unbalanced.

Crude, products imports

A significant development last year was that China's oil imports appeared to be increasingly affected by world market prices and less rigidly controlled than in recent years. The world oil market should take note of this important change and its effect on China's import patterns.

As China's oil market has become more closely tied with the world market, price volatility and fluctuations elsewhere have negatively affected the Chinese market. When world oil prices were low, oil smuggling prevailed and supply surpassed demand, upsetting the equilibrium of the domestic price-regulated system. When world oil prices were high, smuggling and imports declined, resulting in a tight domestic market and soaring oil prices.

On the other hand, the Singapore diesel oil market has become significantly more dependent on Chinese buyers in recent years. China is likely to purchase a great deal in 1997 if prices do not increase substantially, but South Korea threatens to take market share from Singapore.

All diesel imports in China are subject to volume quotas. Under the central-planning system, China's oil importers receive an annual quota and a foreign-exchange apportionment from the government.

The government metes out quotas, and, while businesses cannot exceed them, they do have some flexibility as to the timing of purchases over the course of the year. The quota and hard currency allotments are approved 1 year in advance and can be adjusted only in extreme cases.

High oil and products import prices mean importers must reduce their purchases of other hard-currency-denominated imports in order to spend a larger share of their hard-currency allotment on oil. As a result, they prefer to wait until prices fall instead of allowing purchases to drain their limited hard-currency fund.

Because importers hope to buy oil and products at lower-than-world-market prices, they tend to postpone purchases in anticipation of a price dip. This frequently leaves a large segment of their quota unused at yearend.

But importers must use their entire quota to prevent the government from reducing it the following year. So they often scramble to make purchases in December and fulfill their quota allotment at the last moment.

This situation worsened in 1996. Due to high world crude prices, there was a dramatic drop in imports.

In 1996, government-issued import quotas totaled 140,000 b/d for diesel. Only 90,000 b/d of diesel was imported, however. About one third of the quota went unused because of soaring Singapore diesel prices, which peaked at $34/bbl-the highest level since the Persian Gulf war.

This dramatic drop in diesel imports was a reversal of the trend toward higher imports that developed during 1995. The import cut forced China's refineries to increase output: diesel production in 1996 rose 90,000 b/d from 1995 but still fell far short of demand.

High oil prices in 1996 increased production costs for those refineries that process imported oil. In 1996, the average cost in these refineries was up as much as $3/bbl. But while these refiners had to pay higher prices for crude, they were still obligated to sell products at government-regulated low prices, causing most to lose money.

Faced with the alternative of purchasing diesel and fuel oil at high world-market prices, China opted to increase crude imports and refine this crude to meet domestic needs. In 1996, diesel imports declined substantially while oil imports rose 110,000 b/d, a 32% increase from 1995 levels.

China's economy is expected to maintain growth of 8-9% this year. As a result, ESAI expects diesel demand to increase further. Chinese diesel importers will be watching the Singapore market in an effort to time major purchases to periods of lower prices.

If the Singapore diesel market maintains prices of $23-24/bbl or less, Chinese diesel oil purchases will likely return quickly to their planned quota level (about 140,000 b/d). Diesel prices have not fallen below $25/bbl, however (other than the short drop experienced during a few days early this year). If these high prices persist, Chinese importers will probably continue to be hesitant about entering the world market on a large scale.

Acknowledgment

This paper is rewritten from work performed by the author at ESAI. The author thanks Edward N. Krapels, Monica M. Ferreri, and Raoul Leblanc for their comments, suggestions, and assistance.

The Author