China is back in the market for sweet crude oil ahead of the release of new import quotas for independent refiners — but demand for the sourer grades favoured by state-owned firms looks weaker.
In this episode of The Crude Report, vice presidents Tom Reed and James Gooder discuss the two sides of China’s crude market.
James: Hello and welcome to another edition of The Crude Report. This is a regular podcast coming to you from Argus Media. My name is James Gooder. I'm VP for Crude in Europe and Africa, and I'm joined today by Tom Reed, who's the editor of Argus China Petroleum and our expert on all things China and crude and products markets. Thanks for joining me, Tom.
Tom: Hey, James. Nice to be with you.
James: Well, good to have you with us. I should say, in the interest of full disclosure, we recorded the podcast around a week ago, and it was all ready to go but then everything changed as everything does in China. So maybe you could tell us a little bit about some of the new tax rules that have really shaken things up. We heard about these on Friday, right, the 14th.
Tom: Yeah, yeah. So that is, obviously, how I like to end my week, my Friday evenings, interpreting the rules put out by the Communist Party on the new tax system in China. This is the big news obviously that from mid-June, China's going to imply a consumption tax on a range of blending components at a similar rate to those it already applies to finished road fuel, gasoline and diesel. So around $40/bl, essentially, for gasoline and diesel – [a] chunky, chunky tax. And this is a potentially really disruptive move. We're talking about close to 1mn b/d of petroleum trade. That breaks down to about 370,000 b/d of trade in light cycle oil, and diluted bitumen, and mixed aromatics. Now these are some niche-sounding products, but they have become very, very central to the way China's road fuel market operates.
James: How so?
Tom: Well, so refineries in South Korea last year found that they didn't need...they didn't have an outlet for all of their light cycle oil, which is intermediate product quite often used as cutter stock for bunkers. And they began sending it to China. And the reason they did this was that when the bottom fell out of the crude market in April last year, China set a floor price on the pumps of gasoline and diesel, which ensured a huge refining margin. So the price difference between gas oil in Singapore and gas oil in China blew out to about $30/bl. And Chinese product traders could obviously pay a lot more for light cycle oil which they can blend with jet, which, of course, no one needed because no one was flying, to produce kind of that gas oil. And you get a lot of blenders and trading companies in China selling this blended gas oil at a price which significantly undercuts the refinery gate price of conventional fuel.
Source: Argus China Petroleum
Sinopec, the world's largest refiner and obviously a national oil champion in China, has been cutting up pretty rough about this – not been happy. They've been losing a lot of market share to this cheap fuel. They began lobbying the government in March, just before China's annual National People's Congress met, to try and get the tax rules around this change. They wanted, essentially, LCO, light cycle oil used to produce gas oil, and mixed aromatics, basically reformate used to produce gasoline, to be taxed at an equivalent rate to level the playing field. Which, you know, it's the reasonable position for them to take. Rumors of this tax began circulating in the market in April. There was a rumor that it was going to be introduced at the start of May. So cue a little bit of panic, you know. And then a lot of people, at the same time, are saying, "This lead time is too short. No way can they organize this revolutionary tax move in such a short space of time." And they didn't, it didn't come in on the 1st of May, but they have announced that it will come in in mid-June.
James: Wow. So this is clearly good for Sinopec, right? They've got what they've been lobbying for. But who's losing out?
Tom: Well, that's a very good question because they have a saying, a phrase in China, "the state advances and the private sector retreats," which is I think, to some extent, what we're kind of seeing here. What is good for Sinopec is going to really hammer those blending and trading companies that were making handsome profits from producing road fuels from blending tanks.
Another really important thing that's happening is that in addition to taxing those, which are used to produce road fuels, the government's also announced that it's going to tax a product called diluted bitumen at the same rate that it currently taxes fuel oil. Diluted bitumen, when it arrives in China from largely storage tanks in Malaysia, is actually heavy sour crude. And so far, and historically, it's been imported under the name of diluted bitumen by independent refiners. And what that means is that if they're importing diluted bitumen as refinery feedstock as a product, it's not eating away at these refiners' crude import quotas because it's coming in as a product. So this is another, sort of, salvo that has been fired essentially at the private sector as a result of these tax changes. From mid-June, the diluted bitumen will be taxed at $30/bl. No one's ever paid $30/bl tax on a refining feedstock, so that is going to be a very disruptive factor in the market, in particular, in Shandong which is a big bitumen-producing country.
James: Absolutely. And what does it mean for the kinds of crude that China will be importing?
Tom: Well, I mean, it does raise some really interesting questions. China is a big bitumen producer. It has this huge road-building agenda. A lot of the bitumen producers come out of Shandong. So they are, you know, presumably going to need some heavy sour crude. I think one of the things that's going to be really interesting is how much more competitive this is going to make alternative sources of heavy sour crude in China, you know, hitherto grades like Canadian Cold Lake, or Iraqi Basrah Heavy, or Colombian Castilla Blend. You know, these have struggled to compete on price in the Chinese market because the diluted bitumen, which is often Venezuelan Merey, tend to price very, very deep discounts to futures. And that does mean that other grades will struggle to price into the market. So I think, you know, there is going to be, again, a leveling of that playing field. But I think on a net-net, what we're looking at is potentially a drop in imports of heavy sour crude.
James: Interesting. I mean, a lot has changed since we last spoke about this stuff. Now, how did the market look last week? I seem to remember you were telling me that those more sweet crude was in demand, particularly in the independent refiners and they were burning through their quotas hoping for repeating and, you know, of course, for the coming year. What's the situation now?
Tom: Well, that was true a week ago. That was true a week ago. We saw the independent refiners come back into the market with a vengeance for sweet crude, you know. There was a lot of latent pent-up demand there which kicked in. We saw trade in Brazilian pre-sold crude in April rise to about 900,000 b/d, and a lot of that will be arriving in July. And so, you know, this has obviously...this has kind of knocked that sideways. A lot of refiners in China now are looking at, you know, the economics of crude imports going forward.
But I think somewhat what's happening in parallel with these tax changes, the government has also decided to crack down on the reselling, the trading of crude import quotas, the crude import quota in China. China has become essentially a fungible asset. And, you know, if you are running your refinery hard, you can have...to date, been able to buy a quota from someone who's not running their refinery hard on. And the government now wants to crack down on that.
That's going to have some quite interesting implications for Chinese imports of Iranian crude. I think it's very possible that we will see the amount of Iranian crude being cleared through Chinese customs by refiners on behalf of other companies really, really come down from the very high levels that we have seen in the market this year. And those really, really high inflows of Iranian crude have proved terribly disruptive to sweet crude markets. You know, they hit sweet crude money. They didn't hit sour crude markets and they priced into Shandong. So if that flow chokes off, we could potentially see that Iranian crude backed out again from the Chinese market.
James: And given how central China is to everything in these markets that we look at, is it possible then that we will see kind of further opening up in the spreads between light and heavy as the market is starting to digest the extra Opec medium and heavy crude coming back, China perhaps taking less Iranian crude leaving that kind of backed out in a market that's not necessarily able to take it? Do you think we'll start to see those spreads open up further?
Tom: I mean, those light heavy...sorry, sweet sour spreads have been extremely high to the point now that, you know, in the Chinese market, we have Lula pricing around $1.50 over futures, and we have Oman's perfectly good crude, you know, but sour pricing just 10 cents over futures. And I think, you know, if the Iranian crude is backed out of the Chinese market, that is going to probably support prices for sweet crude, because that has been displacing a lot of those anti-basin imports.
James: Fascinating stuff. So in terms of the product demand in China, how's that looking? And are these types of changes likely to affect the way the products are consumed?
Tom: Yeah. Well, I mean, product demand in China has actually been really quite healthy, which...I mean, and I think hopefully, you know, it does kind of...it is maybe the template to the way that other economies are going to emerge from Covid. And we've seen certainly the tourism data over the latest Chinese public holidays actually rise back to 2019 levels. So, you know, that amount of activity, and with all the implications for economic output, are sending quite positive signals. I think if the blended fuels get shut out of the Chinese market by these tax changes, then you would obviously, potentially, it'd put a lot of upward price pressure on the products market. I think you could see domestic prices rise. I think you could see Chinese exports of clean fuel fall.
And it's interesting that this is coming at a time when as countries emerge from lockdown, we are seeing inflation kind of creep back onto the political agenda. We are seeing central banks getting more pressure to kind of look at ways of containing inflation rates. It was interesting that the U.S. inflation data, which was seen as pretty bearish for oil markets actually was matched by an inflation rate in China of 9% in the latest reporting period for April. So I think, you know, tightening product supplies is definitely going to fuel inflation in the Chinese market.
James: Indeed, and perhaps support products prices in other markets if China is exporting less.
James: Well, it's a fascinating wound up. Thanks very much, Tom. Hopefully not too much will change again before this is broadcast tomorrow. Today is the 18th. And I'd like to thank everybody for tuning in, and we will have further updates as things go along. So these changes are coming in in June. So a lot to watch out for. So that's it.
Thanks very much for tuning into The Crude Report. This has been James Gooder and Tom Reed. Do look out for the next edition of the Argus China Petroleum report in which all will be revealed. Thanks again for listening.
Tom: Thanks, James.