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China's recent move to digitally tag fuel cargoes to clamp down on the widespread practice of declaring crude purchases as fuel oil to evade taxes is already seen to be curbing demand for heavy Venezuelan Merey crude from teapot refiners in Shandong province, sources said Thursday.

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"We are not hearing many deals of Merey crude concluded recently, as it is no longer easy to manipulate the invoice," said a source with Hengruide Petrochemical, an 800,000 mt/year (16,000 b/d) refinery in Shandong.

A source with Huifeng Petrochemical, a 4.8 million mt/year refinery in the province, said it is not using any Merey crude this month, without specifying why. Last month, it processed 35,000 mt of the crude.

There are around 54 teapot refineries in eastern Shandong province with a total crude distillation capacity of 113.55 million mt/year, according to Beijing-based energy information provider JYD Commodities Hub.

A JYD survey of 36 of the refineries found they consumed 5.14 million mt of Merey crude in 2013, out of a total crude consumption of 28.18 million mt.

The new reporting procedures aimed at combating counterfeit tax invoices were implemented February 1.

The State Administration of Taxation or SAT has adopted a technology that individually encrypts value-added tax invoices for crude, fuel oil and naphtha cargoes with digital and Quick Response Codes -- optically machine-readable labels -- that contain detailed information about the cargo, including the identities of both buyer and seller and the volume traded, and whether it is subject to consumption tax.

The labelling aims to stamp out the widespread practice of teapot refineries declaring crude oil purchases as consumption tax-paid fuel oil on a VAT invoice, then escaping paying consumption tax on their finished oil products as the feedstock had been declared as fuel oil.

All oil and oil products in China are subject to VAT, typically levied at 17%, but not all oil products are subject to consumption tax, for which the rate varies.

Crude oil in China is not subject to consumption tax, but a Yuan 0.8/liter or Yuan 812/mt ($133.10/mt) consumption tax is levied on fuel oil.

Oil products sold to end users are not subject to consumption tax if they have been refined from fuel oil, while products refined from crude oil are.


Shandong's teapot refiners traditionally relied on imported fuel oil as their main burning feedstock as crude import quotas were awarded to only a handful of state-owned major companies.

However as China's imports of crude oil have risen in recent years, adding to overall supply, the state-owned majors have become more willing to sell cargoes to teapot refiners.

PetroChina, the country's main importer of Merey crude, usually sells the grade to its affiliated teapot refineries in Shandong, Hebei and Liaoning provinces.

These refineries in turn have been known to resell some barrels to other independent refineries if they can make a profit, and this is mostly done by declaring the cargoes as consumption tax-paid fuel oil in VAT invoices.

These other refineries then escape paying any consumption tax on their finished oil products as their crude purchase had been declared as fuel oil.

Similarly, some crude from the domestic Shengli field, which is operated and sold by state-owned Sinopec, is also being declared as fuel oil and resold to independent refineries.

The only way for teapot refiners to be profitable was through these tax loopholes, as their margins are razor thin and they need to price their oil products below those of state-owned refiners to be competitive, sources said. Despite this, for now, the new tagging system seem to be working.

"No one dares take the risk to purchase feedstock without paying the required taxes at the moment," the source from Hengruide said.

The industry is waiting to see if there is a way around the new system, another refinery source said.

For the moment, teapot refineries will probably be much more discerning about their feedstock purchases, and will choose to buy the most appropriate feedstock for the finished product requirements in order to minimize how much consumption tax they pay, sources said.

If their main products are gasoil and gasoline, they will need to buy consumption-tax paid feedstock like imported straight-run fuel oil. But if they produce petrochemical products like propane and ethylene that are not subject to consumption tax, they could use crude.

"This will depend on each refinery's unit and will vary from refinery from refinery. But as far as I know, the main products from Shandong teapot refineries are still gasoil and gasoline," the Hengruide source said.

--Edited by Song Yen Ling, and Wendy Wells,