Chinese crude oil markets reawaken

Author Argus

The global oil market is looking toward China for tangible signs of a worldwide revival. Still the world’s largest oil demand center, China is seeing a healthy return of crude demand, particularly in Shandong, their main import hub.

Tom Reed, Vice President, joins Jeff Kralowetz, Vice President Crude and NGLs, to examine the mix of state-owned and independent Chinese refiners, the favored grades for import and how imported barrels are being priced.

Global oil market highlights


Jeff: Hello, everyone. This is Jeff Kralowetz from Argus, and we'd like to welcome you to our podcast on one of the trends that are shaping the global crude markets. With me, today, is Tom Reed, the lead developer of our news coverage in China, and more recently of our market coverage in the exceptionally liquid crude markets that have sprung up in the maritime provinces of Shandong. So, welcome, Tom.

Tom: Hi, Jeff.

Jeff: Maybe the best place to start with this would be a quick history on how the mix of state-owned and independent refiners has sprung up in China. And especially, I think people would be interested in how Shandong has become such an active importer of crude.

Tom: Yeah, absolutely. Well, historically, of course, China's Communist Party has maintained control of the commanding heights of the economy, a central pillar of which has been the energy industry, through a handful of very large state-owned firms, chiefly Sinopec, PetroChina, CNOOC (which focuses on offshore drilling) and Sinochem, which was mainly a trading company, commodity trading company. But a few years ago, the government deregulated crude imports and that allowed a load of small independent refiners, which had grown up around one of the Sinopec oil fields in [the] Shandong province in the north of China just near Beijing, to begin importing crude, and that obviously diversified China's oil sector quite considerably. And then, more recently, a clutch of very, very large primarily textile producer companies, Rongsheng, Hong Li, also Shenghong, these companies have opened massive, new, very, very integrated downstream refining and petrochemical facilities designed mainly to produce feedstock for PTA plants, and they have also become significant crude buyers.

The independent refiners, though, which you've mentioned in your intro there, used to be known as teapots, that is, I suppose, a term that is still common currency. It's not one that they greatly appreciate because in many cases, you know, they're quite sophisticated operations with deep refining conversion capabilities and international trading arms. So, we tend to refer to them as independent refiners. And we differentiate the independent refiners. Those are the typically small scale, unintegrated refineries in Shandong and Liaoning province further to the northeast from what we call other greenfield refineries, which are the newer, larger plants of the type, I suppose, typified by the Rongsheng or the CNOOC, big refineries there. So, that has really changed the landscape of China's oil market because when the independent finders of Shandong province went out...were allowed into the market to buy crude for the first time, you know, they didn't have that sort of breadth of international experience which their larger state-owned peers had. So, they very much wanted trading companies to deliver crude to Shandong port.

They didn't want to go into the North Sea market and figure out, you know, the various CFD mechanisms and all that kind of thing. So, they said, "Just send the crude here. We just want you to price it a differential to ICE Brent, which is really nice and straightforward. And we will pay you usually a premium to ICE Brent crude futures just to deliver that cargo of crude to ports around Qingdao in Shandong province." And the growth in demand that we've seen there has been absolutely astronomical, and Shandong now accounts for usually between 30% and 40% of China's total crude imports. And let's not forget, of course, that China is the largest crude importer in the world. And Argus has been very much at the forefront of pricing that new market, developing pricing solutions for trading companies looking to supply crude to independent refiners.

Jeff: Wow, that's a lot for us to jump into here, but thank you for that overview. One of the big takeaways that I take from that and something that was surprising to me for a while was just the level of sophistication of some of these independent plants and their ability to take crude really from all over the world. But I guess the top of mind, right now, is how China, Asia, and the rest of the world is responding to [Covid-19], and how badly demand has been hit by COVID. We are seeing some stories of healthy returns to economic activity in China. And I'm just wondering what that's doing to China's interest in buying crude again.

Tom: COVID obviously hit China harder and earlier than the rest of the world. So, we began to see China go into lockdown in late January, and in February, a very, very dramatic contraction in demand, which we've now seen kind of spill out into the rest of the world. And refinery runs there, which was quite a good kind of measure of the strength of prompt demand for oil, essentially fell by about 2.5 mn b/d between January and February. So, in outright terms, you know, that meant that crude runs in China had fallen from, maybe, 13 mn b/d to slightly over 10 mn b/d over the course of February. But demand rallied, you know, very, very quickly as China came out of lockdown. And part of that, interestingly enough, was because the government still controls pricing for fuels at the pump, so gasoline, diesel, it sets a cap on pump prices. And as part of the mechanism is, it uses to set those pump prices when crude prices fall below $40/bl, it starts adjusting prices.

So, even the demand was quite low, on paper, you had this phenomenal refining margin. When crude prices went down to about $20/bl, you know, you were looking at margins of $20, $30/bl and that triggered a huge increase in crude purchasing understandably. And because it's a long-haul market in China, it trades for usually three months ahead, they were buying crude in February for delivery in May. And we saw that in the data for May, which recently came out. We saw record crude deliveries to China in May, and we expect that growth in demand to continue through June and July.

Jeff: Well, great. And I assume that there are some favored grades that get delivered regularly into the Chinese coast. Which are those?

Tom: The main grades favored by independent refiners tend to be quite sweet and quite distillate-rich and that's historically been because diesel...gasoil has been the main output of the independent refiners. And they've tended to lack, maybe, the same extent of the hydrotreating capacity that some of the larger refineries have. So, we have managed to capture pretty amazing liquidity for the grades that we launched assessments for in 2018. And we're now assessing prices for five grades, all of which have had pretty amazing liquidity. We've got Russian ESPO blend, which is the only short-haul grade in there that comes out of the far east port of Kozmino in Russia and sails around about five days to Shandong province, Djeno from Congo in West Africa, Oman from the Middle East, which has a relatively sour grade. This new North Sea grade, Johan Sverdrup, from Norway, very, very popular, very huge demand we've seen for Johan Sverdrup, but the main grade, I guess the baseload grade you could say, is Lula from Brazil.

China: Brazilian pre-salt crude purchases

(Source: Argus China Petroleum)

And certainly when we were looking at the number of deals done that went into our assessment in May, Chinese refiners in total, on a delivered to China basis, bought around about 800,000 b/d of Lula for delivery over the summer. That is a staggering amount of Lula. I mean, that's pretty know, that's a large, large chunk of Brazil's exports. And I would say probably the majority of the country's pre-salt offshore production of medium sweet crude.

Jeff: And particularly, interesting for us, price reporters, the price of Lula is not particularly transparent at the Brazilian coast, but it appears that it's very actively and openly traded at the Shandong coast.

Tom: Yeah. And interestingly enough here, the same is true of Johan Sverdrup where there are very, very few deals for Johan Sverdrup taking place in Europe, and all of the real price transparency that we see in the market is on a delivered China basis, both the Johan Sverdrup on new assessment and the Brazilian Lula. And, you know, we get phenomenal degrees, I think, of deal disclosure there which really underpin, I think, the robustness of our assessments. And you can see how those differentials to ICE Brent have just gone up dramatically far more steeply actually than the underlying flat price. In the end of April, some of these grades were trading at $5 under Brent, and they are now $3 above Brent, which is a really big swing in price.

Des Shandong vs Ice Brent

(Source: Argus China Petroleum)

Jeff: And so, as we talk here, I'm sitting a few miles away from the Houston Ship Channel, and there is lots of US crude that would love to go to China. Do you see US grades gaining much foothold in the Chinese market this summer or beyond?

Tom: That is a very interesting question. Obviously, we had this phase one of the trade deal between China and the US happen in January before COVID hit. Even then, I think there was a view, a very defensible view, that this was mainly a political arrangement, that a lot of those numbers were not really very practical, even at prices in July, because it was based on a sum of money not a volume of crude. And as the price fell, the implied volume of crude that China would have to buy, crude or LNG, has increased dramatically and almost certainly unrealistically. The idea that China could hit those targets implied by the phase one deal, I think, is pretty unlikely. Where US crude goes to China, it'll go to China because it's pricing very competitively. And we did see that when the price war started after that failed Opec+ meeting in Vienna in March. We saw a lot of competitive discounting of barrels into China.

And for a while, US Mars did become the most attractively priced type of sour crude that was trading into China. That's not happening lately. It was a kind of brief flurry of activity. But we will, I think, see quite a large chunk of US crude delivered to China in July. And we're not sure whether that will be sustained, not least because the relationship between Beijing and Washington has obviously deteriorated quite dramatically since that deal was signed. I think a lot of refiners now will be very cautious about buying US crude in the current political climate.

Jeff: Great. Yeah. We wish we had a clear crystal ball there. We did talk a little bit about pricing. But what do you see about the pricing of imported barrels at the Chinese coast? And particularly, I guess I wanted to ask you about this INE futures contract that the Chinese launched a few years ago. How are people using that and what's the delivery mechanism for this physically delivered contract?

Tom: That's an interesting question. Because I think China, like Russia, you know, is very keen that it not be a price taker, that it establish a kind of unique local benchmark and, you know, other grades would price differentials to that benchmark. It hasn't really taken off. It's become more of, sort of, a retail instrument. There's quite a lot of trade, you know, daily trade volumes, pretty impressive on the INE futures contract rather lower open interest and actual physical delivery. And where there is interest from the trading community, it seems to be mainly occurring when a large price discrepancy appears between the INE market and DME Oman prices, which is another medium sour benchmark. And Omani crude is very much seen as the baseload grade for delivery into INE tanks.

Due to some...a shortage of storage space when COVID struck, the premium of INE to DME prices went absolutely ballistic. It went to sort of $14 over DME prices, and that did attract a certain amount of interest, but the trouble was, of course, there weren't any tanks for sellers to deliver that crude into. So, the INE has been scouring the country to try and locate and secure additional storage tanks for traders to deliver crude into. It's been relatively successful in doing that, I would say, by allowing storage company operators to charge very, very high fees to store crude. So, maybe, five or six times the normal cost of storage you would get if you lease your tanks for INE delivery. But even now, no one's really using it to price physical barrels into the markets, more being used, as I would say, one wouldn't say a speculative trading gambit, but it's not really being used for physical delivery.

Jeff: Okay. Thanks a lot for that. Tom, I think we have time for one more question before the clock runs out on us here. And I just wanted to draw you out a little bit about this, maybe, surprising transparency that we see in the trade of crude at the Chinese coast. People don't automatically associate China with transparency, but you and the team in Beijing kind of noticed this active spot trade going on for cargoes like Lula and others and started doing daily assessments of them. And I guess my question is, how is that going, and how are people using those prices that you are reporting on every day?

Tom: Well, we're seeing quite a lot of interest in using those prices to the extent that we've now just launched a crude report in Chinese, a daily crude report in Chinese that allows the local refineries and trading companies, who may not be so comfortable reading the report in English, to look at our prices and scrutinize them in Chinese. We do understand that seems to be going very well. And so, we hope soon, you know, people will be taking these as more than just, I guess, a reference for when they're pricing cargoes on a fixed differential to ICE Brent and start, maybe, a shift towards floating prices, which would probably allow them to hedge a lot of those sales better because it's a really risky gambit that to selling crude three months ahead on a fixed price basis, trying to hedge that is currently quite tricky, but these obviously would allow people to roll with the punches and move with the market.

Jeff: This is all fascinating. I think that the world is watching China. It's the leading demand center and surely will be for quite a while in crude and other energy commodities. So, anyway, thanks for your insights on this. And thanks to everybody for joining us for this podcast. We hope to be back soon with another conversation about trends that shape the global crude markets. Thanks to everyone.

Tom: Thanks a lot, Jeff.

Global oil market highlights