Factbox: China's independent refiners under pressure as Beijing tightens scrutiny

Recent measures by Beijing to tighten supervision of the independent refining sector have clipped the wings of the largest contributors to China's crude import growth since 2016 and are expected to alter the country's refining landscape by forcing shutdowns and consolidations.

There will be some near-term impact on crude import volumes as smaller refiners struggle to survive, but the overall expansion in refining capacity should offset this in the long run.

China's refining sector is split into refineries owned by state-owned oil giants and those owned by private companies, with the key difference being that the latter need quotas to import crude oil. Beijing liberalized the sector in 2015 when it began allotting crude import quotas to independent refiners, accelerating the country's crude import growth trajectory. Prior to this, these refiners relied on fuel oil and domestically produced crudes for feedstock. For Beijing, the goal was to boost competition for state-owned refineries, remove inefficiencies in the sector and incentivize plant upgrades to control pollution.

Over the years the government has been tightening scrutiny of independent refiners, particularly the smaller plants based in Shandong province -- the largest independent refining hub -- to try and eliminate illegal practices. But the recent crackdown on tax irregularities and illegal quota trading is the toughest to date by the government on these refiners, forcing them to lower operating rates and even consider closures.

The measures include more stringent investigations into crude import quota use, which has led to a reduction in quota allocations; stricter tax rules that have squeezed margins; and the imposition in June of a consumption tax on imports of bitumen blend, rendering this alternative feedstock used by independent refiners uncompetitive.

There are a few reasons behind Beijing's move to crack down on practices it had been turning a blind eye to for the last few years. One is the need to boost tax revenue amid a pandemic-induced slowdown, another is a stronger need to reduce greenhouse gas emissions after a declaration of carbon neutrality by 2060 by President Xi Jinping. A third is the emergence of mega, integrated independent refiners. These integrated refining and petrochemical complexes are large and efficient enough to keep the markets well supplied and competition alive, making it easier for the government to tolerate capacity losses at small, scattered, inefficient and polluting plants in Shandong.

Independent refiners account for around 35% of China's total refining capacity of around 900 million mt/year (18 million b/d).

Below, S&P Global Platts takes a look at the impact of the crackdown on infrastructure, trade flows and prices

INFRASTRUCTURE

** A clampdown on the illegal quota trade, in which refiners with crude import quotas sold them to non-quota holders, has left the latter with no feedstock. Around 15 million mt/year of such refining capacity based in Shandong is expected to shut permanently amid difficulties in procuring feedstock.

** Refiners that have added capacity illegally are likely to idle part of this capacity amid stronger government surveillance and a shortage of feedstocks such as bitumen blend. At least four independent refineries in Shandong have added a total 16.5 million mt/year of capacity illegally since 2017, according to industry sources.

** The new measures will accelerate a plan by the Shandong provincial government to consolidate refineries with capacities under 5 million mt/year to cut the sector's capacity to 90 million mt/year by 2025 from 130 million mt/year in 2018.

** Several independent refiners are open to consolidation and to transferring their crude oil import quotas to new refining and petrochemical projects, as they see exiting the business as a more viable option. So far, 10 Shandong independent refineries have firmed up plans to dismantle 27.5 million mt/year of refining capacity and transfer their 13 million mt/year of combined crude import quotas to the greenfield 20 million mt/year Yulong project in the province, which is scheduled to finish construction in 2022.

* There are currently two mega private integrated refineries with a combined capacity of 60 million mt/year – Hengli and Zhejiang. Two more such refineries with a combined capacity of 36 million mt/year are expected to come on stream by end 2022.

TRADE FLOWS

Crude Oil

** Shandong independent refineries' crude oil imports, including bitumen blend, have been in a downtrend since June and hit 1.98 million b/d in August -- the first time below 2 million b/d since April 2020, S&P Global Platts data showed. Volumes are unlikely to see a strong rebound in the rest of the year.

** Malaysia, Russia, Oman, Brazil and the UAE were the top suppliers to Shandong's independent refiners in the first eight months of this year, Platts data showed. Russian supply fell almost 17% year on year over January-August as pressure on these refiners reduced demand for Far East ESPO crude, and imports from Brazil fell 31% over the same period. Malaysian crude supply includes bitumen blend, which is expected to fall going forward due to the consumption tax.

** Crude imports by the Shandong refineries comprised about 24% of China's total crude imports of 10.44 million b/d in the first eight months of the year. State refineries are likely to lift crude imports to make up for the drop in inflows to independent refiners.

** Independent refineries are expected to rely more on domestically produced crude oil. Consumption of domestic offshore crudes by the Shandong independent refineries has risen 20% to 1.08 million mt/month since June, compared with 885,000 mt/month last year.

Bitumen Blend

** China's bitumen blend imports fell sharply following the imposition of the consumption tax in June. Trade sources expect volumes to remain at very low levels in the coming months. Bitumen blend imports hit a monthly record high of 4.15 million mt in May ahead of the tax implementation, but fell to 880,000 mt in August, Platts and customs data showed.

Fuel Oil

** Shandong's independent refineries have resumed fuel oil imports to partly compensate for the reduction in crude imports. Fuel oil inflows for the sector were estimated at 494,000 mt in August, up from 143,000 mt in June, Platts and customs data showed.

Oil Products

** Shandong independent refineries' gasoline and gasoil stocks hit an 18-month high of 1.5 million mt in August as the higher tax burden made their barrels less competitive amid lackluster domestic demand.

PRICE

** The premium for ESPO, the most popular feedstock for Shandong independent refineries, against Platts Dubai averaged $1.97/b over Sept. 1-14, down from the monthly average of $3.15/b in June, Platts data showed.

** The premium for Brazilian Tupi, another popular crude, averaged $1.256/b against Asian Dated Brent on a DES Qingdao basis over Sept. 1-14, down from $1.76/b in June.

** CFR China straight-run fuel oil barrels were offered at Platts 180 MOPS plus around $75-$80/mt Sept. 14, jumping from a premium of around $50/mt in May.

** Bitumen blend import costs rose Yuan 1,376/mt ($213/mt) due to the new consumption tax. Offers for the feedstock fell to minus $13-$14/mt to ICE Brent futures on a DES basis Sept. 14 from a premium of $1/mt prior to June 12 before the consumption tax took effect, but the reduction has not been deep enough to offset the tax cost.

** Gasoline and gasoil prices have been rallying in mid-September due to throughput cuts at these refiners following the launch of environmental investigations, with gasoil rising Yuan 600 ($93)/mt or 11.1% and gasoline Yuan 500($77.50)/mt or 9.4% in the past week.