Understanding China’s domestic oil market is akin to following an opaque and moving target, but a new report by independent price reporting organization Platts highlights the changing dynamics of one area in the Chinese oil market that is most responsive to economic signals: China’s teakettle refiners.

Playing Against Monopolies

Monopolized by state-owned but publically listed companies, market fundamentals in China’s growing oil sector often compete against soft targets from Beijing. For years, in the absence of concrete data from the larger players, China’s teakettles (the small independent refining sector that makes up approximately 30% of the country’s capacity), acted as an imperfect but insightful barometer for the domestic market. The new study by Platts unveils a very different landscape for both teakettles and the larger state-owned companies from what existed just a few years back.

While China’s refining sector is dominated by state-owned companies Sinopec and PetroChina, both are publically listed companies traded in Hong Kong that also answer to the needs of Beijing. That means the refiners are sometimes called on to supply the market even when the economics don’t make sense (fulfilling their civic, not fiduciary duty) but are ensured minimal domestic competition in return. And outside of a cluster of independent refiners in Shandong province, along the coast southeast of Beijing, the state-owned companies have little threat to their monopoly. In Shandong, however, teakettles account for 60%, or 3.8 million barrels per day of local refining capacity. Their location is a mix of historically favorable policies such as access to cheap land and a provincial government that grew reliant on the industry for jobs and contributions to the GDP.

For years, teakettles have been a gauge for the overall domestic oil market. Restraints on the independent sector (see sidebar) make competing with larger, more complex state-owned refiners almost impossible.  Rather than compete, teakettles bought feedstock from the same companies they sold their products to. But they also served a valuable function – their excess capacity was called on in times of tight markets. Teakettles absorbed excess fuel oil from the big refiners, using that as their feedstock instead of crude.

Teakettles face tough market conditions that their larger, state-owned counterparts mostly avoid. These include:

• Beijing limits crude import licenses to a select few. Most teakettles cannot directly import crude from the international market, and must instead buy crude from one of China’s state-owned companies (PetroChina, Sinopec or CNOOC), who have not always been eager to share.
• Unable to procure enough crude oil, teakettles often relied on fuel oil for their feedstock. Much of this came from state-owned refiners, but some was imported from places like Russia and Kazakhstan.
• Likewise, independent refiners do not hold export licenses, so their fate is completely tied to the domestic market.
• Teakettles do not produce jet-fuel, but most try to optimize their diesel/gasoline output.
• Most teakettles have little presence downstream (in retail operations such as gas stations) and are forced to sell their product back to state-owned companies. With just a few buyers, teakettles are typically price-takers. Retail prices for end products such as gasoline and diesel are set by the national government.
• Most independent refiners have the backing of local government, helping keep them viable even if directives from Beijing are to shut them down.

All of this made teakettles the best option to understand domestic markets. When refining margins went negative, teakettles utilization rates plummeted (often well below 30%). Contrast that to the state-owned refiners, who posted negative refining margins year after year, investing in new refining capacity and forced to supply the market even when Beijing pegged domestic gasoline and diesel prices below the cost of production.

A Changing Game

Facing many difficulties not shared by their state-owned counterparts, the teapot’s survival during a period of decreased Chinese oil demand growth over the past few years is remarkable.

Under pressure from Beijing, Shandong took measures to consolidate and eliminate much of the local capacity a few years back. But policies meant to discourage activity resulted in the opposite; small players invested in building new capacity to stay relevant, viable and too big for the government to shut down. According to Platts “Compared with 2000, the scale of Shandong’s independent refiners had risen by more than 25-fold by late last year.” Beyond expanding refining capacity, some teapot producers are looking to expand downstream, giving them an option outside of selling back to the state-owned companies. Platts points to 12 million ton per year refiner Dongming, which “has set its sights on developing 10 new storage facilities and a chain of up to 1,000 retail stations,” according the report. As of now, teapot refiners control just 300 of the 10,000 retail stations in the province, says Platts.

Even efforts meant to clean up the air and prevent pollution have proved unpersuasive to local governments, who rely on the sector for economic growth. “Last year they generated Yuan 336 billion ($54.9 billion) in revenue, Yuan 5 billion in profit and paid Yuan 37 billion to the state and central governments in taxes,” according to the Platt’s report. 

The slowing pace of growth in oil demand and a refining slate that produces less fuel oil has left China’s large refiners with excess crude. This opened a window for the teakettles to make supply deals. Platts says that just a few years ago, only 33% of teakettle’s feedstock came from crude. Today that ratio is 85%, and a growing amount of it sourced from foreign imports. While most teakettles still lack an import license, “With ChemChina successfully getting crude oil import rights, the teapot refinery sector is eagerly waiting for more quotas to be approved for non state-owned companies,” said Platts.

Alliances with state-owned players favor both parties, but allow the teakettles to flourish. For PetroChina, a strategic partnership in Shandong gives the company an edge in a downstream market formerly controlled by Sinopec and gives the teakettles feedstock supply assurance.

Not All Tea and Roses

While the rules may have shifted, teakettles still face significant hurdles. “The landscape for these refiners has been changing, as they now have to grapple with shrinking credit, slowing growth in oil products demand, and weak margins,” according to the Platt’s report. The national government is rightly concerned about the environmental ramifications of these smaller producers, many of whom do not meet national standards. A push for consolidation and a tightening credit market will make refiners more reliant on help from provincial governments. And their inability to export continues to tie their fortunes directly to the domestic market. Still, Shandong’s teakettles provide valuable insight into the domestic market.