China's independent refiners could get regulated away: Fuel for Thought

China’s regulatory pendulum has swung from supporting independent refiners by encouraging competition and deregulation to favoring state-owned oil companies, which could have the impact of regulating many of the independents out of business.

In early 2015 China’s independent refiners, or teapots, were set to soar. Beijing’s policy makers gave teapots permission to import crude and export refined products.

Regulators are now reminding independents that they really are not independent. In 2017, rather than giving teapots full year import quotas, regulators will allot the quotas in several rounds, and the first round was delayed by half a month.

If the allocation had been further delayed, “we would not have enough feedstock to sustain normal runs in the refinery in addition to having to pay a high demurrage,” said a source at a Shandong-based independent refiner.

The government has also yet to award refined product export permits to independents, which under what is called the “processing trade route,” allows refiners to not pay taxes on the exports.

Without the export permits, independents would end up paying taxes on refined products exports, forcing them on the domestic retail market, where they lack a competitive edge.

Fueling stations, which supply about 80% the road transportation fuel in China, are owned by state-owned companies Sinopec and CNPC’s PetroChina. To be competitive, independents have to sell gasoline at about Yuan 1,000-Yuan 2,000/mt lower than their state-run competitors, an amount they can ill afford to charge and stay profitable.

Why the about face on teapots?

China’s government wants to reduce excess refining capacity and clamp down on independent refiners’ environmental non-compliance and tax evasion.

The state-owned CNPC’s research arm estimated China currently has 15.14 million b/d of refining capacity, with teapots making up roughly 4.5 million b/d of that.

China processed just 10.83 million b/d of crude oil in 2016, according to data from the National Bureau of Statistics, suggesting nearly one third of the capacity is surplus.

Independents typically operate well below capacity, but with crude import quotas and product export quotas they were able to boost utilization rates to nearly 60% in 2016 from 30%-40% before 2015.

But the independents have run afoul of regulators when it was found they were violating certain aspects of the import quota agreement. The refiners were found guilty not only of tax evasion, illegally reselling imported crude to non-quota holders, but also failing to fulfill their promises of phasing out refining capacities or building LNG storage.

Nearly all of those investigated, big or small, were fined up to Yuan 1 billion ($145 million) in 2016, market sources said, and import rules became more strict.

“It’s difficult for us to make a profit without tax evasion,” said a Shandong-based independent refiner, a sentiment echoed by many of the others in the province. China’s teapots may also have simply lived out their usefulness as a supply stopgap during a widespread anti-corruption campaign against state-run refiners launched a few years ago under President Xi Jinping.

The campaign resulted in the removal of several high profile senior officials from the three biggest state-owned companies—CNPC, Sinopec and CNOOC.

While the anti-corruption investigations were ongoing there was a worry that the nation’s energy security could be at risk and independent refiners were given greater liberties in order to maintain China’s growing appetite for oil products.

But since the purge of top executives, the state-owned firms are found to be running smoothly and the need for independent refiners has come into question.

Even without permits, independent refiners can still export refined products, but would need to pay taxes, including a VAT and consumption tax. China’s government last month allowed a rebate on the VAT for refined products, and has indicated it may allow a rebate on consumption.

The VAT rebate may help independent refiners, although even with a consumption tax rebate, independents would continue to have cash-flow issues as they must pay all taxes up front.

China exported 3.04 million mt of refined products in January, up 1% year-on-year. Exports are expected to rise this year, although that increase will likely come at the expense of the independents.