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Outlook 2017: China's Independent Refiners Face Uncertain Times

China's independent refiners face uncertain times in 2017 as the government comes down hard on them for compliance and tax evasion, and has rowed back from allowing them to export refined products.

Beijing allowed independent refiners access to imported crude oil in early 2015 and to export oil products in late 2015. Their emergence, which came at a time of excessive oil supply, made them the darlings of oil suppliers.

But 2017 is going to be fraught with challenges, which may undermine their profitability and slow their crude import growth.

Below S&P Global Platts examines the effect these challenges will have on independent refiners and on the country's overall crude oil imports.

Crude Oil Quota Allocations

China's National Development and Reform Commission is expected to issue crude import quotas of around 20 million mt/year to new independent refiners for 2017, down 19% from 2016, according to Platts estimates.

A total of 14 refineries have applied for a combined quota volume of 30.89 million mt/year for approval in 2017, but around 20 million mt/year, or two-thirds of the total amount requested, are likely to be approved.

The downtrend has been clear. In 2016, the NDRC approved 24.58 million mt of new crude import quotas to eight independent refineries, only half of the 49.19 million mt/year the commission allocated to 11 refiners in 2015.

"The government will definitely continue to approve new quotas to independent refineries, but the slow reviewing process means fewer quotas will be allocated," a refinery source in Shandong said.

The NDRC has said it will tighten supervision to ensure independent refiners are adhering to all rules before awarding them quotas.

Effect on China's Crude Import Growth

China's crude oil import growth is likely to slow down to a pre-2016 level of around 8% in 2017 as independent refineries are faced with lower quota allocations and uncertainty over their ability to export products.

Independent refiners are estimated to have imported 45.96 million mt of crude oil in 2016, according to Platts estimates based on shipping data.

This compares with an estimated total imports of around 10 million mt/year of crudes by 11 quota holders in 2015.

Crude imports by the independent refiners pushed up China's imports in 2016 to an estimated 378 million mt/year, up 12.8% year on year, according to Platts China Oil Analytics.

However, crude import growth is likely to slow down to a pre-2016 level of around 8% in 2017, according to COA.

The government has tightened supervision of the sector to prevent illegal re-selling of crude and tax evasion, a COA analyst said.

This along with not allowing them to export oil products will impact overall imports by independent refiners, the analyst added.

Move Towards Sweeter Crudes

With China moving towards a cleaner fuel standard from January 1, some independent refineries have started to buy crudes with lower sulfur content.

Hengyuan Petrochemical, an independent refiner in Shandong, prefers to import crudes with sulfur content below 0.8%, according to a company source.

The refinery in 2016 imported over 1.4 million mt of crudes, with most grades sourced from Angola.

The portion of Angola crudes, typically grades with sulfur below 1%, in the crude basket has increased to around 10%, according to Platts estimates based on shipping data. This compares with an estimate of around 1% in 2015.

"Crudes with lower sulfur content usually have lower carbon residue and metal contents, so they are pretty good feedstock," said the source.

In November and December, cargoes of Brent crudes, as well as Forties blend, arrived into Shandong ports for the independent refineries, setting a new trend.

While the price of crudes with lower sulfur is higher, their greater quality can translate into higher refinery returns, depending on the cost of desulfurization of crudes with higher sulfur content.

"On average, refineries this year have been making a good profit of around Yuan 200/mt," said a refinery source, encouraging the purchase of more costly crudes with lower sulfur content.

More crude diversification can also be expected in 2017 as some independent refineries have increased their ability to adapt to crudes with higher sulfur content in recent years, after setting up desulfurization units.

Export Uncertainty

Removal from the oil product export quota allocation in 2017 is perhaps the biggest blow dealt to independent refiners who were all set to invest in infrastructure to facilitate exports.

China recently awarded export quotas for the first quarter of 2017 and independent refiners were not given any quotas under the processing trade route, which allows direct exports with no applicable taxes on the product. While the share of exports among independent refineries in 2016 was relatively small -- they exported around 700,000 mt of gasoline, less than 8% of the country's total, according to COA -- it did help reduce surplus and competition in a weak domestic market.

"Direct exports from independent refineries are not much in terms of volume, but the sharp increase in output from independent refineries have eaten into oil majors' domestic market share, forcing them to export more oil products into the overseas market," said a trading source.

Independent refiners may still be allowed to export oil products through the so-called general trade route by asking stated-owned trading companies to export products on their behalf, but this option has not attracted much enthusiasm.

"Firstly, we need to pay the agency fee if we are to export through other companies," a source with Dongming Petrochemical said. "What price we supply oil products at and who takes the profit are also critical questions."

"Secondly, it is time-consuming and inefficient, as more communication is required if exports take place through external companies," the source said.

"Thirdly, if we export through Chinaoil, for example, we're just a domestic supplier, instead of an international supplier that can respond quickly to market changes, so we will have less negotiating power in future, not only with international buyers, but also with those domestic agents."

Products Output

Fewer quota allocations, heightened government supervision and no export quotas have all rendered the outlook on products output uncertain.

But one Shandong-based source pointed out that output will likely continue to rise following the higher crude throughput supported by more crude quotas to be allocated.

China's total output of oil products was estimated at around 438.16 million mt in 2016, up 5% year on year, slightly higher than the 4.3% growth registered in 2015, according to COA.

This was largely driven by the higher output from independent refineries, according to COA.

Data provided by energy information provider JYD suggested that total output of gasoline and gasoil from Shandong independent refineries increased by around 81% to 54 million mt over January-November.