CHINA PETROLEUM TRADE, INVESTMENT POISED FOR MAJOR GROWTH NEAR TERM

Value of China's Oil Trade (15591 bytes)
China's Petroleum Imports and Exports (22623 bytes)
China's 1993 Refined Products Supply/Demand By Region (75134 bytes)
Petroleum trade and investment in China are poised for major growth.(28454 bytes)

With one of the world's fastest growing economies, China's consumption of crude oil, refined products, and petrochemicals is expected to continue to increase sharply for the foreseeable future.

Because of the country's limited ability to boost its productive capacity significantly anytime soon, trade in these petroleum based commodities had been soaring until a series of market reforms last year. Beijing took steps in 1994 to slow the pace of petroleum imports out of concern for an overheating economy.

China became a net importer of refined products in 1993, a net importer of oil overall in 1994, and is expected to be a net importer of time, the country remains one of the world's biggest importers of petrochemicals, a status certain to continue in the near to medium term.

Despite the slowdown in petroleum trade caused by market reforms last year and the need for still more reforms, a number of factors dictate that some progress on this score is forthcoming soon. That in turn suggests that a trend of continuing growth in China's petroleum trade will resume and parallel an improving climate for petroleum investment.

MARKET REFORMS

Growth in Chinese imports of crude and products had been strong, and exports of both had been shrinking until last year, when market reforms reversed those trends.

It wasn't the first such government intervention in petroleum markets.

Beijing in late 1992 allowed market pricing for a portion of domestic crude oil production. At the same time, the government relaxed import controls on crude and refined products.

It was those reforms and the expectation of a 17% value added tax being imposed in January 1994, that sparked a scramble bv traders to import oil into China near the end of 1993, says J.P. Morgan Securities Asia Ltd., Hong Kong. This created a huge inventory overhang in China and forced some refineries to cut production as much as 50%.

The government on Mar. 1, 1994, decreed that all imports of oil would again be placed under government control.

On May 1, 1994, Beijing unveiled a new pricing system for crude oil and refined products. Accordingly, an importer now must secure a quota from the State Planning Commission (SPC) before it can apply to the Ministry of Foreign Trade and Economic Cooperation (Moftec) for a license to import crude or products, renewable quarterly. J.P. Morgan sees both steps as temporary setbacks for market liberalization in China's oil sector.

INVESTMENT CONCERNS

The international petroleum industry's continued concerns about the pace of government progress allowing investment in China's oil sector remain justified, analysts say.

"The reluctance to allow foreign access to its 'riches' is a recurring theme in Sino-foreign business relationships and ... has contributed to much of the delay in China's development," J.P. Morgan said. It cited limited access to onshore exploration and haggling over the allowed rate of return to foreign investors in the electric power generating sector.

Those investment concerns are justified in China's downstream petroleum sector as well, contends East-West Center's (EWC) Fereidun Fesharaki.

"Foreign investment in the Chinese refining industry has been extremely weak despite several years of discussions and hundreds of visits to China by international and national oil companies," Fesharaki said.

"With the exception of the Total-Sinochem Dalian joint venture, which has been under construction for several years, no joint venture project is likely to be completed bv 2000.

"This poses a potentially serious problem for China, in which a lack of adequate refining investment might make China so heavily dependent on product imports that Chinese demand alone could drive up international product prices, thereby inflating China's oil import bill."

PETROLEUM PRICE REFORMS

A major impediment to investment in China's upstream is the low domestic crude oil price, in w c crude produced within quota levels is 10-4017, less than the international price.

That's why state owned onshore exploration and production company China National Petroleum Corp. (CNPC) lost money 8 years in a row prior to 1994, a key reason for underinvestment in the E&P sector and a lack of major discoveries in recent years, J.P. Morgan contends.

China has made several attempts to reform its petroleum sector t e past

In the early 1980s, the government implemented measures allowing joint ventures with foreign partners in offshore exploration, acquiring foreign technology and equipment, and allowing direct foreign investment in oil.

Under this regime, Beijing introduced a dual price system, notes J.P. Morgan. The system called for the first I 00 million metric tons of crude oil production each year to be sold at a low government determined price, called the state low price. Any production exceeding that amount could be sold at a high government determined price, or state high price.

In the early 1980s those prices worked out to about $5/bbl and $24/bbl, respectively.

These reforms have produced steadily rising crude oil production since 1983, but China's reserves/production ratio has continued to slide.

Based on official exchange rates for yuan/dollars at the time, the state low price averaged $4.35/bbl in 1990 and $5.70/bbl during 1991-93. The state high price was about $14.50/bbl in 1990 and $13.90/bbl in 1991-93.

The latter prices were 15-40% lower than world prices at the time. However, because the yuan was considered overvalued, the price received at times probably was 50% lower than international prices, J.E Morgan said.

In 1993, the government decided to allow about 15% of the country's crude oil production to be sold outside the dual price system.

In May last year, the new policy set domestic crude oil prices at levels that were closer to international prices but still 15-40% below those prices.

On the refined products side, Beijing first set prices according to the price refineries paid for their crude supply. However, refineries were allowed to sell products at market prices, resulting in a situation in which CNPC was losing money and key downstream company China Petrochemical Corp. (Sinopec) was making a healthy profit, J.P. Morgan noted.

Refined product prices currently are set bv the State Council's State Administration of Commodity Prices, with the spread between wholesale and retail prices kept at 10-13% and the net profit margin at less than 3%.

Petrochemical prices were allowed to be determined bv supply and demand in 1993 but were returned to government control last year.

IMPLICATIONS FOP INVESTMENT

Fesharaki contends that Beijing's May 1994 petroleum price policy change had two important implications for foreign investors:

• By fixing prices higher than international levels, the government sent signals to investors that its policy could potentially guarantee a refining margin higher than that enjoyed by Singapore refiners. At the time, the gross refining margin was $13/bbl for Chinese refiners compared with $6.24/bbl in Singapore.

• Beijing has fixed prices based on internal calculations that are peculiar to the Chinese economy, not easily understood, and without reference to international markets.

"Under this policy, the Chinese government can at any time change prices at will," Fesharaki said. "Foreign investors, who are placing billions of investment dollars at risk, will face financing problems if there is no refining price based on the international market.

"China reduced prices in August 1994, reducing gross refining margins by $1.38/bbl. This is a great uncertainty that discourages investment since there may be other unilateral price changes in the future."

Fesharaki said Beijing should move petroleum prices to a floating rate above Singapore prices and maintain absolute differentials in Chinese product prices relative to those in Singapore. These differentials will dictate the direction of refinery economics and investment, with no need to change prices every day. A trigger price moving within a range can be incorporated in the system, he suggested.

Fesharakai notes another impediment to foreign investment: Beijing did not offer an official explanation of its May 1994 policy to potential foreign investors, resulting in confusion, misinterpretation, rumors, and uncertainty. He recommends that the government provide prompt explanations of policy in English.

At the same time, foreign companies have been given a very strong impression their presence in China's retail market is not welcome, Fesharaki noted, with Beijing setting up regulatory barriers to market entry and taking steps to cut marketing margins. He contends China won't be able to attract foreign joint venture partners to enter the Chinese refining business unless it offers firm assurance of access to the domestic retail market.

Fesharaki also sees the need for common ground between foreign refining investors and Beijing's strict policies on technical and management control of joint venture refineries, with both sides needing to agree on ground rules for management.

The upshot is a need for more reform.

"There is little doubt that the reform program has achieved what it can, but it is now time to move forward ... The SPC needs to embark on the second phase of the reform program, and it is now time to put together the elements of the second phase," Fesharaki said. "Meantime, foreign investors are trying to buy time by carrying out extended feasibility studies."

Fesharaki warns that the cost to China will be high if it waits too long to implement further reforms.

"Attractive opportunities are available in other countries, and much needed funds and technology may be diverted elsewhere," he said. "If that happens, China's product import dependence will swell, which in turn will cost China dearly in money and credibility

"We believe key decisions by the Chinese government need to be made before the end of 1995. We hope these decisions will be positive and effective."

CHINA AND WTO

Another development that figures into Chinese petroleum trade, investment, and market reforms is the proposed entry of China into the World Trade Organization, successor to the General Agreement on Tariffs and Trade.

J.P. Morgan thinks the prospect of entry into WTO could be the catalyst to spell out and put in place a clear policy for developing China's petroleum sector. Such a policy would go a long way toward eliminating the "stop-go" approach that is hindering foreign investment.

As for entry into WTO, J.P. Morgan expects the Chinese government to seek to have the refining and petrochemical industries included as protected industries whose products tariff rates will be reduced during an extended period.

"However, the nontariff barriers and government-set prices may become subjects of heated debate, as it is the goal of the WTO to disallow nontariff barriers other than for developing countries and as a means to balance payments," the investment analyst said.

Those two issues aren't expected to be much of an issue for the petrochemical industry in China, which to a large extent has been liberalized and likely faces a long period for reducing tariff rates, J.P. Morgan noted.

The two issues will be of concern for the refining sector, however.

Eliminating the nontariff barriers and state prices almost certainly would disrupt domestic supply and demand, J,P Morgan contends, if the distribution system is not rationalized and a reasonably well developed transportation and storage infrastructure is not in place.

"Imbalances caused by local inefficiencies could cause prices of refined products to fluctuate wildly, which may result in interrupted industrial production, something the government would try to avoid," J.P. Morgan said.

"The chaos toward the end of 1993 caused by a surge in the import of oil products is fresh in the mind of government officials and ... provides a good argument for government regulation on the refining sector being relaxed slowly and in step with development of supporting infrastructure."

REGIONAL IMBALANCES

EWC also conducted a study of the regional dissimilarities and imbalances that underscore the problems with China's petroleum sector.

To better understand China's current petroleum market, EWC divided the country into eight regions that reflect current differences in development, particularly the rapid growth and role of coastal provinces in China's economic development and oil consumption (see map and table, p. 16 (62693 bytes)).

The Honolulu think tank noted that China's refining industry traditionally has been highly concentrated in regions with significant crude production.

Refining capacity in the three northeast provinces, where more than half of China's crude is produced, accounted for about 31% of the national total. Refineries in the northern petroleum region accounted for another 21% of total capacity. Refineries in the Lower Yangzi provinces and Guangdong provinces serve the coastal demand centers, where little oil is produced.

Comparing shares of products output, crude output, and refining capacity, EWC found that product output is generally proportional to refining capacity in most regions, but in the crude producing regions, the share of product output in total national production is usually higher than the share of total national refining capacity.

EWC pointed out that one of the most important factors shaping China's oil market today is the gap between North and South, commonly divided along the Yangzi River.

In 1993, North China, with 41% of the population and 42% of total gross domestic product, produced 88% of the country's crude oil. South China, with 57% of population and 56% of GDP, produced only 5% of the country's crude. North China also produced 60% of all refined products in China that year vs. 34% for South China and consumed 52% of refined products vs. 44% for South China.

Accordingly, EWC noted, South China needs a large supply of crude from North China for its refineries, with that need certain to increase as more refineries are built in the South. Another option is for South China refiners to buy low sulfur crude on the international market.

While the government wants to transport more crude and products from North to South, the high cost, poor pipelines-especially for products-and other limitations prevent it from doing so.

Since late 1993, South China refiners have been struggling between two incompatible objectives: Beijing's order to cut refinery runs and their own fight to secure more foreign oil.

During much of second half 1994, imports of crude were restricted, even though refinery utilization had fallen to 50% in some South China refineries. South China also needs large volumes of refined products from either North China or the international market, which further deepens the North-South gap.

In addition, rocketing economic growth in South China compared with the North's means South China's share of total oil consumption, currently 44%, will increase.

"In the long term, massive investment is needed to improve oil transportation facilities between northern China and southern China, or a more liberal oil trade policy has to emerge in order to alleviate the growing oil shortage in southern China," EWC said.

The imbalance between North and South has largely fueled the recent boom in oil imports and drop in oil exports. In recent years, more than two thirds of China's imported products have been taken by the southern coastal province of Guangdong, whose economic growth rate is said to be unsurpassed in the world.

EWC thinks the oil supply gap between North and South will persist, even if the vast hydrocarbon prospectiveness of the remote West is realized and well developed according to Beijing's plan.

"More oil from western China means longer pipelines are required to transport the oil across the country," it said. "Infrastructure may therefore become the ultimate determining factor for the regional integration of China's oil market."

1894 OIL TRADE

China's crude oil and refined products imports plummeted 24% in 1994 from 1993 levels to 25.24 million metric tons, the lowest level since 1991.

Products imports slipped 25.4% in 1994 to 12.89 million tons, including gasoline, naphtha, kerosine, light diesel, heavy diesel, fuel oil, liquid petroleum wax, and lubricating grease. Crude imports last year totaled 12.35 million tons, down 21% from the year before.

Accompanying the drop in petroleum imports was a decline in petroleum exports.

Petroleum export earnings in 1994 fell 17% from 1993 to about $2 billion, accounting for only 1.6% of China's total export earnings.

At one time, exporting crude was China's major source of foreign exchange. In 1985, when crude exports reached a record 30 million tons, China netted $6.9 billion, accounting for 38% of total export earnings for that year.

CRUDE TRADING

China's 1994 crude exports fell to their lowest level since 1983 at 18.49 million tons, down 4.8% from 1993.

China's crude exports last year came almost exclusively from Daqing and Shengli producing areas at shares of 81% and 18%, respectively. About 60% of China's crude exports went to Japan, with the rest going to the U.S., both Koreas, Singapore, Israel, and Indonesia.

Crude exports have fallen an average 4%/year since 1985.

Given Sinopec's estimated 1995 crude demand of 139 million tons and projected crude supply from CNPC of 87.7 million tons and from China National Offshore Oil Corp. of 4.6 million tons, China will need to import 20 million tons of crude this year.

Sinopec in 1995 is expected to produce 34.2 million tons of gasoline, 38 million tons of diesel, and 4.2 million tons of kerosine against respective projected demand of 34.8 million tons, 44.8 million tons and 3.4 million tons.

Given China's yearend 1994 product stock levels estimated at 7 million tons, domestic supply of refined products will fall short of demand by 7.5 million tons, including 600,000 tons for gasoline and 6.8 million tons for diesel. Beijing is advising state traders to import more diesel and export more gasoline.

Of China's total crude export volume in 1994, China United Oil Corporation (Chinaoil) exported 6.618 million tons of crude for sale and 303,000 tons of crude as payment for international loans on behalf of CNPC, respectively about 550,000 tons and 1,257,000 tons short of target.

About 5.85 million tons of Chinaoil's crude exports came from Daqing, China's biggest producing region. Chinaoil exported most of its Daqing crude supply to Japan, which imported a total 9.3 million tons of crude in 1994.

In 1994, China's crude imports fell to 12.35 million tons, their lowest level since 1990 and a drop of 21% from 1993. About 54.6% of China's imported crude came from other Asian countries.

The plunge in crude imports was caused by bloated domestic crude stock levels that resulted from the May 1994 freeze on imports.

The ensuing stock drawdown in turn forced CNPC to shut in several hundred producing wells because of reduced demand for field crude. The glut persisted through the second half. China's crude imports fell to 5,016,350 tons in fourth quarter 1994, down 42.52% from 1993.

Chinaoil, as a proxy of CNPC, in 1994 imported its first crude 30,000 tons. Although that is far short of its 1994 quota of 100,000 tons, CNPC considers the volume significant.

Chinaoil is one of three Chinese traders authorized by the state to import and export crude and refined products in the wake of last year's reforms. The other two are China International United Petroleum & Chemical Corp. (Unipec) and China Petrochemical Corp. (Sinochem).

MINAS IMPOSTS

The seasonal flurry of refinery turnarounds worldwide in tandem with falling U.S. gasoline stocks has helped keep a prop under crude oil prices, with Asian crude markets especially tight.

The price for Indonesian Minas spot crude, a mainstay of Chinese refiners, rose 6.55% in early February to an average $18.45/bbl.

The bullish turn for the Asian spot market in February forced China to reduce imports of Minas crude in the first half. Instead, domestic traders will import more stably priced crude from the Middle East, notably Oman.

China expects to import 8 million tons of crude in the first half, mainly Minas and Omani crude.

Beijing cannot eliminate Minas imports for now. Some refineries, especially those in Northeast China, such as Dalian, are not capable of running sour crudes. Sinopec is trying to obtain more crude from Cnooc and CNPC to feed the northern refineries and urging southern refineries to run more Middle East crudes,

In 1994, China imported 4.72 million tons of Minas crude, up 22% from 1993 and accounting for 38.3% of China's total crude imports. Oman was the runnerup last year, with imports of that crude totaling 3.37 million tons, or 27.3% of the total.

PRODUCTS TRADING

In 1994 refined products trade, China's imports of heavy diesel posted the biggest drop-71.2% to 205,000 tons.

Although light diesel imports sagged 30.5% last year, they topped the list of China's product imports at 6 million tons.

Squeezed by domestic surplus, gasoline imports fell 51% to 1.053 million tons in 1994. Increased demand for fuel oil, spurred by expansion of power generation capacity in the southern provinces, prompted China to import 3.98 million tons of fuel oil last year, up 2.8% from 1993.

Naphtha imports posted growth in 1994 of 50% from 1993 to total 407,000 tons.

The naphtha imports were channeled to Qulu in Shandong, Yangzi in Jiangsu, and Maoming in Guangdong as ethylene feedstock.

However, due to the international naphtha price slump in early 1994, some domestic traders imported more naphtha for refineries to blend low octane gasoline.

Market analysts predict China's naphtha imports will exceed 1 million tons in 1995.

Since China liberalized prices for refined products in September 1992, retail gasoline and kerosine prices have been climbing steadily. That has prompted local traders to shift more supplies to domestic markets, including those that had been export-oriented. That led to a 30% products export slump in 1993, with a total 3.7 million tons.

In 1994, China exported 3.79 million tons of refined products.

Spurred by domestic surplus, Sinopec increased exports of gasoline from refineries in Northeast China in 1994. Starting in third quarter 1994, China's gasoline exports have exceeded 250,000 tons/month.

LPG IMPORTS

China's LPG imports rose 103% in 1994 from 1993 levels, reaching 1.37 million tons.

Guangdong province in South China accounted for about 82% of the national total. Other importing provinces include Shanghai, Zhejiang, Jiangsu, Hainan and Fujian.

In Guangdong, domestic LPG supply continues to dwindle while imports soar.

Guangdong consumed 1.37 million tons of LPG in 1994, of which 1.12 million tons were imported and only 250,000 tons came from local refineries, including Guangzhou and Maoming.

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