As Chinese citizens demand cleaner air, but put more cars on the road, Beijing is retooling its policies towards fuel standards and pricing, while Chinese refiners adjust company strategy. Watch for these forces to play out in the next few years, with the potential for ripple affects throughout Asia, especially in the gasoline and diesel markets.

A Shift to Gasoline

In basic terms, Chinese demand for fuels is moving away from the old guard of industry and towards new areas of growth. In other words, growth in oil product demand is now fueled by gasoline, not diesel.

In the past, Chinese refiners maximized diesel production. Diesel was second only to coal as the backbone of the Chinese economy, powering industry, the agricultural sector and transportation (trucks, not cars). But changing dynamics in both transport fuels and a shift by industry towards using natural gas caused diesel demand to flat line over the past few years.

The accounts are staggering.

• While gasoline demand skyrocketed by almost 60% over the past five years, diesel hasn’t kept pace, according to industry-watcher Platts.

• Diesel accounted for 38.5% of total apparent oil demand back in 2008, but that shrunk to just 34.8% in the past five years.

• Gasoil accounted for around 5% of overall product demand growth last year, while gasoline made up almost 75%, according to CNPC’s research institute.

• China’s largest refiner, Sinopec, increased gasoline output by 12.36% in 2013, while diesel production stayed flat from a year before.

• Diesel demand is only expected to increase by 3% per year until 2020, lagging overall growth in oil.  Meanwhile, gasoline demand is expected to grow by 6% annually, according to CNPC.

The changing dynamics and expanding refining capacity leave China with excess diesel production that it will get rid of on the Asian market. With two new greenfield refineries opening this year, that excess could turn into a glut and drive down already low refining margins. PetroChina actually lost 5.3 billion yuan on its refining sector in the first three quarters of last year (source, page 6) while Sinopec turned around negative margins to make a profit of 6.656 billion yuan over the same period (source).

 Already, China is exporting diesel. Exports started increasing in 2012, reaching 200,000 barrels per day last year. These are likely to hit 250,000 b/d this year, according to a Singapore-based analyst. China produced around 3.5 million b/d from January – November of last year (source in Chinese).

Gasoline (and an environmentally-conscious public) Opens Doors

The shift to gasoline and demand from its citizens to clean up the environment gives Beijing an opportunity to increase fuel prices for the consumer, not the refiner. (Chinese pump prices are set by the NDRC, not oil companies.)

Traditionally, Beijing tried to protect consumers of transport fuel, since they represented drivers of growth. But with more demand coming from gasoline – a fuel that represents new wealth, not manufacturing or agriculture – and with 20-30% of China’s overall PM 2.5 emissions blamed on vehicles, Beijing floated a new proposal last September (source in Chinese) that would ensure customers pick up the tab for higher quality fuels. This should help expedite adoption of higher fuel standards.

This is good news to anyone breathing air in a major Chinese city. In the past, demand for cleaner fuels was met by major resistance from Chinese refiners trying to protect margins. With assurances that they won’t bare the costs alone, refiners are more likely to comply with state laws.

But other smaller changes have been afoot at the NDRC, with the method and frequency of fuel price adjustments. Prices in 2013 were adjusted at a higher frequency than they had in the past (see chart). Still, shifting the burden onto consumers will be a gradual process. And, Beijing wants all diesel to meet China IV standards by the end of the year (source in Chinese) and the China IV standard for gasoline went in effect last month. As a result, analysts say refining margins are likely to drop this year.

But the shift in government policy hasn’t yet resulted in cleaner air or higher prices at the pump. Rather, both of China’s largest oil producers were cited for breaching regulations at their refineries and put on the Ministry of Environment’s (MEP) pollution blacklist. Sinopec said it will spend over 22.9 billion yuan ($3.6 billion) on environmental projects over the next three years.

Beijing needs to tread carefully in upping prices for transport fuels, even if the public is demanding more efficient, cleaner burning gasoline. And how state-owned refiners deal with lackluster diesel demand in the face of new refineries coming online could impact the Asian diesel markets.