The Crude Report: Competition for Chinese demand heats up

Author Argus

The competition to supply crude oil to Chinese markets continues, with Canada being the latest player to up their game.

In this episode of The Crude Report, our vice presidents Jeff Kralowetz and Tom Reed talk through China’s current market condition, their government's latest initiatives around import quotas and the impact on Canada’s future aspirations to directly supply this market.

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Transcript

Jeff: Hello, everyone, and welcome to this edition of The Crude Report. This is our podcast series on trends in the global crude oil markets.

And today we want to look at China's demand for Canadian crude. This is an important topic as Canadian crude production seems set to grow again by about 100,000 b/d each year. And there are new pathways being developed to get Canadian crude to the water, both at Vancouver on the Canadian west coast and at the US Gulf coast.

So my name is Jeff Kralowetz - I do business development for Argus in crude and NGLs out of Houston. And today, joining me is my colleague Tom Reed, who is editor of our monthly
China Petroleum report, and who leads business development efforts for China. So hello, Tom.

Tom: Hey, Jeff. Thanks very much for inviting me on.

Jeff: So maybe I can set the stage a little bit, and we'll get right into some questions about Chinese demand. But it looks as if there's going to be a lot of additional crude produced in Canada of the type that could compete in Chinese markets against Middle Eastern barrels, Venezuelan, Brazilian, Russian, and West African. Alberta's bitumen and conventional crude production is already back above pre-Covid levels, and the Alberta Energy Regulator sees output climbing to about 4.4mn b/d by 2030. So, definitions are always tricky, but this 4.4 would include heavy raw bitumen, which is typically blended with a diluent to make grades like WCS or Cold Lake, and it also includes sweet upgraded bitumen that's partially refined and the conventional crude out of Western Canada.

And one more definition, I think we should have a clarification on the word “bitumen”. When Canadians talk about bitumen, they typically mean the 10° or 12° API - really heavy crude that has to be diluted with condensate, or butane or something, to run through pipelines, or partially upgraded to create a light synthetic crude. But I think, Tom, in most of the rest of the world, bitumen kind of means the heavy product that comes out of the bottom of the distillation tower.

Tom: Yeah, exactly. Yeah, there's a little bit of confusion we should clear up there. When we talk about bitumen in China, we are talking about the stuff they lay on roads.

Jeff: Yeah. Well, maybe I hit you with the first question, which is just how strong is China's demand for Canadian crude gonna be going forward?

Tom: Right. Well, you know, China has really ambitious plans to expand its highway network in the current five-year plan period that runs to 2025. So, underlying it all, we do have this kind of quite robust demand for what we could call bitumen rich crudes. Of course, currently, demand for those grades, the bitumen rich crudes, is pretty weak. But this needs to be seen within a broader context of what's going on in China's oil market. And it's a potentially more complex question than simply looking at the number of new refineries being planned as, you know, latent demand, implied demand, or the Chinese government's plans for laying new roads. It gets to the heart of a lot of the regulatory, above ground challenges, facing the Chinese market right now. And those are very, very hard to second guess. Broadly speaking, though, you know, there are two distinct sectors in the Chinese oil market, and I'm talking about refineries really. State-owned firms have usually fairly sophisticated refineries that'll run pretty much any kind of crude they want, and they'll switch between grades based on refining and arbitrage economics.

The independent sector, and by this, I chiefly mean the smaller refineries which typically account for the bulk of China's bitumen production, the stuff you lay on roads. These guys will switch between sweet grades, you know, such as Brazilian Tupi, Russian ESPO blend, for producing motor fuels, gasoline, diesel, depending on price. And they will also buy a certain amount of base load heavy, sour crude, which they use to produce bitumen.

Jeff: Okay, great. Yeah. Thank you very much. So, I know we're trying to look ahead a little bit, a couple years, about what the demand in China is going to be, but there is a lot going on in China's government right now regarding steps to cut back on crude imports, especially by the independent refiners. I'm wondering if you could tell us something about the ratcheting back of import permits for crude and export permits for refined products, and the effects all of this is going to have for Chinese demand for crude.

Tom: Yeah, no, I mean, this is the issue which underpins everything we see in the market, really, is the government's increasing intervention in oil markets, which had become relatively deregulated. We are now in a situation where for four straight months, you know, imports, crude imports have come in below 10mn b/d. So, sharply down on some of the bullish numbers that we saw in the back end of 2020, at the start of this year, some really, really high numbers. The Chinese government, which controls private sector firms' access to crude via a quota system, has come down really hard on the abuse or perceived abuse of that system in volume terms. So it's recently required all private sector refiners to sign a form pledging not to import more than their quotas allow. And that represents quite a significant challenge for the refiners. We're in a situation now where a lot of private firms in China are struggling to access the imports they need to run their refiners, or anywhere near capacity, and are in some cases looking at shutting units.

That doesn't just apply to the refiners in Shandong, often known as teapots, but to some very substantial private sector refineries as well. And this is really where we see little clarity on the government's stance. You know, will it be content to slap rule breakers on the wrist? You know, has it now finished with this process of reprimanding them? Or does it actively want to prune a lot of capacity from the refining sector in China, which is very significant? And we're talking in terms of CDU capacity. You know, the private sector is something in the area of 5mn b/d of CDU capacity. It's big.

Jeff: Yeah, I'm just letting that number sink in, 5mn b/d of refining capacity is more than most countries have. But anyway, one bit of what you were just discussing there is the effects on Venezuela's Merey crude and new taxes applied to it, and I'm wondering if you could explain what happened there and whether you think there's any advantage for Canadian crude coming out of that situation?

Tom: Yeah. You know, so as I mentioned last year, independent refiners imported a lot more than their quotas allowed. A lot of that was Merey. In the past, Venezuelan heavy sour, 16° API Merey, was a key bitumen feedstock. But then of course, in 2019, Merey flows went underground in response to US sanctions. A lot of that was routed via Malaysia to obscure their origin before going into China. Matters became more complicated still in 2020, when Chinese refining margins shot through the roof kind of counter-intuitively during Covid, and that encouraged independent refiners to buy a lot more crude than their quota has allowed them to. And this encouraged Merey sellers to further disguise their crude shipments as diluted bitumen and oil product, so it was not subject to the import limits on crude.

The Chinese government came down really hard on that practice earlier this year, and it's applied a swinging tax to diluted bitumen imports. There's about a $30/bl tax on those now. And in theory, this does open the door to competing grades, those like cold lake, which aren't subject to those hefty fat taxes. But in practice, while Shandong refineries may very well want to import Cold Lake or WCS, unless they receive additional crude import rights, a lot of them are going to struggle to do so just in volume terms.

Jeff: Yeah, yeah. Well, I guess the next step is, what do you think this all tells us about the Chinese government's longer-term approach to imports? I mean, surely, the country is going to continue growing, they're going to need more foreign crude. But will the crude that comes in be headed to the independent refining complex at Shandong, to state-owned facilities? And I guess the step beyond that is, what does all that mean for price transparency? Since you and a bunch of our colleagues in Beijing and Shanghai have developed some really transparent coastal crude price assessments for Russian ESPO and Brazilian Tupi at the Chinese coast, and they trade very actively. So how does this all come together?

Tom: Well, I mean, this obviously is a favorite topic of mine. We developed this way of
assessing crude traded for delivery to that Shandong market. We've seen amazing liquidity behind our assessments, particularly for Tupi, and those have become really useful guides for buyers and sellers in that market. But of course, we only assess prices for non-sanctioned crude, and that's to date, necessarily excluded Merey. It'd be really interesting to see whether the tax is now applied to Merey, to diluted bitumen imports, open up a substantial market for those Canadian crudes.

You know, China imports around 100,000 b/d of Canadian crude already. A lot of that goes into the Shandong province for conversion into bitumen, but Canadian crude faces two big challenges, and I think one smaller challenge.

The first big problem is, as I mentioned, the increasing stringency of checks on refiners' compliance with import quotas. And this is interesting, you know, why we're starting to see these independent refiners, these so called teapots, turn to straight run fuel oil as a feedstock. That's something they used to do way back in the day before the government deregulated crude imports, allowed the private companies to import back in 2015.

The second major challenge is the unwinding of Opec+ cuts, which makes alternative bitumen rich crudes, Iraqi Basrah heavy, and other sort of heavy, sour grade, more competitive on price into China. And the smaller challenge is simply the seasonality of road construction. Refiners in China now are mainly buying long haul crude grades, and that would include, you know, even crude shipping from the west coast of Canada. They're buying for delivery in October, but the road laying season typically runs July, September. And already, we're starting to see bitumen production edge lower, and margins come off quite steeply.

So producers say bitumen margins are currently negative. And that's partly because China has had these devastating floods for the second year in a row. And that's really interrupted a lot of the construction process. I think it's possible we'll see some of that road laying activity spill over into the later months of the year. You know, sort of maybe September, October, we could see a bit of demand pick up towards...in the fourth quarter. But then, of course, the Chinese winter becomes very, very cold and road building essentially stops again.

Jeff: Yeah. I think Canadians can relate to the cold winter. But, you know, looking at it from the North American side, our interest is whether heavy Canadian crude can actually compete in the Chinese market. Because it does look like there's going to be more Canadian crude available. So, the reason...one of the biggest reasons that more Canadian crude is going to come onto the international market is this Trans Mountain Pipeline project, which runs from the oil sands areas of Alberta, to the Westridge docks in Vancouver. And it's supposed to be done in December of 2022, or perhaps early in 2023. But this means an additional almost 600,000 b/d, of mostly heavy Canadian crude that could get to the coast, and a lot of the space on this new pipeline is already committed (
see related news article).

And in fact two of the companies that could ship down the new Trans Mountain expansion are PetroChina and MEG, which is partially owned by CNOOC. Westridge is going to be able to send out three aframaxes (afras) from three different Aframax docks, and about 34 aframax cargoes per month. So that's, let's call it, 700,000 to 800,000 b/d. I guess the question is, can aframaxes of Canadian crude compete in the Chinese market where a lot of the crude comes in on VLCCs?

Tom: Yeah, well, actually, afras are small and relatively costlier than VLCCs. But Vancouver barrels would have some advantage over crude from the Gulf coast. It's a lot shorter shipping distance, 16 versus 45 days transit. And at current rates, both VLCCs from the Gulf coast and afras from Vancouver could deliver to China at a cost of about $2/bl. In some ways, afras might have the advantage of allowing Chinese refiners, and the independent, you know, there are cash flow constraints there, to buy smaller chunks of crude, which could be pretty compelling. Additionally, of course, in the Shandong province itself, while there are quite a few VLCC capable terminals, a lot of the refiners are clustered up near a city called Dongying, which doesn't have a VLCC terminal, but can receive aframaxes. So, you know, that's another logistical advantage that these shipments from Vancouver would get.

As for the China-linked shippers on Trans Mountain, of course, you know, they could sell that crude anywhere. But these are both state-owned companies. It's reasonable to think that some of that would come to China, and I'm sure that the firms currently taking capacity on those new lines will be targeting sales to Shandong bitumen producers. But there is a danger, you know, that the regulatory environment in China may be evolving faster than their commercial planning. And it's possible that demand from Shandong may actually be slighter than they would have hoped. I don't think we're gonna see the kind of exponential growth in demand that we've seen from Shandong in recent years, going forward. I think, you know, the Chinese government would like to cap crude imports into Shandong.

Jeff: So now I guess there's a question about pricing. After all, Argus is a price reporting agency. And it looks like most of the crude sold at the Shandong coast is currently priced as a differential to Ice Brent, but would you expect the Canadian crude to be priced that way?

And I guess before I turn it back over to you, I want to get in a plug for our coverage of crudes going into the Chinese coast. We publish daily delivered pricing for an array of Mideast, Russian, West African, and North American grades, that these prices are based on the FOB price at the homeports, plus the Argus proprietary freight rates into China. And currently, WCS is one of these grades that we look at, going into Singapore and into China, based on the WCS price at the US Gulf coast in Houston, plus the VLCC freight. But I'm wondering, do you think we could get to a point where WCS, other Canadian grades actually get active bids and offers and trades as Brazilian Tupi and Norwegian Johan Sverdrup do?

Tom: Absolutely. It's possible and I wouldn't rule it out. You're quite right, the Shandong market and, you know, a lot of Asian markets tend to trade at differentials to Ice Brent. And when we see deals done for Canadian crude, or bids and offers for Canadian crude, they're almost always on an Ice Brent basis, usually at a discount to Brent, obviously. And it would be lovely to be able to develop an assessment for Canadian grades DES (delivered ex-ship) Shandong. But I do think we would need to see far higher and more consistent trade volumes than we have now for that to be practicable. The solution to that particular problem, of course, could come from these new pipelines that are being laid down to Vancouver. As it becomes cheaper to get that crude to water, it becomes far more competitive to ship to China too, and that's going to help in terms of competition with other heavy sours like Vasconia or Basrah Heavy.

Jeff: Well, yeah, thank you for that. I'm just looking at the time. It looks like we do have to wrap up. But I want to mention that we have seen flashes of Canadian crude, actually reexported from the Gulf coast to China, typically on VLCCs that get loaded off the Texas coast. And a lot of the pipeline crude from China comes into the Port Arthur area and can be shipped out to the VLCC that way. And the flow of Canadian crude to the Gulf Coast has gotten fairly strong in spurts. We've had months over 600,000 b/d of Canadian crude getting to the Gulf coast. So, I guess the final thought is just that we could see Canadian crude getting into Louisiana via an expanded Enbridge Line 3 into the Chicago area, and a restarted large Capline pipeline that will flow from Patoka, Illinois, in the Chicago area, south into Louisiana. One other increment of this is, there's a proposal to build a new barge facility at Lockport, Illinois, near Chicago, that could barge up to 400,000 to 450,000 b/d of Canadian crude down into Louisiana. And that kind of raises the tantalizing prospect of Canadian crude getting to Louisiana and getting out into the storage that feeds the Louisiana offshore oil port, the LOOP. And of course, the LOOP is the only VLCC-capable export facility in the Gulf coast right now.

Tom: Yeah, that would be really interesting, I think. You know, if you look at the way the US market's evolving and growing, and the growing role of light grades like WTI in setting a clearing price for crude in the Atlantic basin. The idea that the US Gulf coast could also see the development of a seaborne heavy sour market price becomes a really engaging possibility too. And I think it would be fascinating to see how that plays into the Asian markets in particular.

Jeff: Yeah. And that's a hot button that I always love to talk to, the
WCS at Houston becoming really the first hedgeable heavy crude price at the Gulf coast. But that's for another day, I'm afraid.

I really appreciate, Tom, that you gave us this look at China's potential demand for Canadian crude, and I want to thank everybody in the audience today for joining us.

And also to remind you that Argus has daily coverage of these markets in the Argus Crude report, and monthly, in Tom's excellent
Argus China Petroleum report. And we also have the ability to do in-depth market studies if you need that for Canadian crude in Canada, or in the US, or in global markets, so please be in touch with us about any of that that's relevant to you, or check out our website at argusmedia.com. And finally, please join us again for another edition of The Crude Report podcast. Thanks so much.

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