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Spotlight: China's long march to consolidate small refineries – Recent measures a game changer?

A version of this Spotlight from S&P Global Platts Analytics was first published April 27.

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China's has stepped up efforts to reform the refinery sector. New measures include the installation of sales to-tax monitoring systems at retail pumps, the crackdown on oil smuggling and an investigation into refineries' compliance with the terms for receiving crude quotas.

Plans to allocate revenues from oil levies to the local authorities may provide incentives to further improve tax collections, as monitoring systems will not cover direct sales of oil products where the sale of offspec, tax free products are most rampant.

Measures implemented so far will not completely eradicate dodgy tax practices or smuggling activity in the near term, but S&P Global Platts Analytics believe many of the steps taken thus far have/will help consolidate the sector and lower the incidences of errant behavior in the sector.

While more refinery closures are imminent, this will likely be a multiyear process and the reduction in runs will not be material to offset growth from new refineries.

In its long march to consolidate small refineries and reform its oil sector where many measures were taken in the past such as upgrading, new policy goals and a strong push by the government of Shandong to cap the province's size of refining, China has now doubled down its efforts again. One of the recent (and more notable) measures include the installation of a sales-to-tax monitoring system at petrol stations in a few provinces, including Guangdong, Henan, and Shandong.

If successful, this is likely to lower the occurrence of tax evasion practices (misrepresenting products as petrochemicals or not producing an invoice) that gave many independent refineries an edge over their state-owned counterparts, i.e. national oil companies (NOCs), in terms of pricing. The tax monitoring system also aims to gradually shift the collection of consumption tax for oil products ($36/b for gasoline and $28/b for gasoil) from the refineries to the retailers.

Platts Analytics noted though that a sizable portion of oil products are not sold through retail stations but directly to customers, particularly in the agriculture and industrial sectors, where the sale of off-spec, tax-free products are the most rampant. Sinopec, alone for instance probably sells around 30% of its gasoil and 10% of gasoline directly to its customers and Platts Analytics believes the share for independent refineries might be higher.

But there will be room for tax collection to improve, in our view. For reforms in this space to succeed, the buy-in from local authorities is crucial, because consumption tax, the single largest levy on oil is a state-tax, and the local authorities often have little incentive to put in effort on collection. While there have been talks of collecting the tax at the pump, it has been put off by the sheer number of petrol stations (more than 110,000) located across the country, so refineries (probably mostly the NOCs) continue to pay them and price their products up accordingly.

But based on media reports, the Ministry of Finance and State Tax Administration has at the end of 2019 issued public consultations on the division of income from the levy between the central and local government, and we are of view that a new revenue-sharing mechanism may well be ready, especially given recent plans for Guangdong to trial the new sales/tax monitoring system in four cities, including Foshan, Zhanjiang, Maoming and Jieyang in April, as well as to promote its use at all petrol stations in the province by the end of this year.

Additionally, Platts Analytics also saw in March an extensive crackdown on oil smuggling (most likely off-spec gasoil from overseas) along the coastal areas, including Zhejiang, Jiangsu, Fujian, and Shandong at the end of March and more recently a special investigation launched by the National Development and Reform Commission to look retrospectively into whether independent refineries' have complied with the necessary terms for receiving crude import quotas, including the mothballing of old and aged capacities below 40,000 b/d, or if new units were added without permits.

These measures came soon after officials from Sinopec reiterated their concerns over unfair competition caused by loopholes in the country's tax system and called for rectification of illegal tax/free product sales. It is also in line with key tasks set out by the National Energy Administration for this year to enhance supervision on refinery upgrades and the elimination of outdated capacities.

Although measures implemented so far will not completely eradicate dodgy tax practices or smuggling activity in the sector, we believe many of the steps taken thus far (even including the recent approval of the merger between Sinochem and ChemChina) have/will help consolidate the sector and lower incidences of errant behavior in the sector. As we highlighted in our previous report, many subscale refineries are already idle and the headroom for these players to maneuver and survive will only become smaller. In our latest update, out of 63 refineries on record, 16 of those with an average capacity of around 10,000 b/d have already ceased operations. Much of this was due to environmental regulations, though some refineries have also moved into other business lines or are bankrupted because of poor margins arising, partially from competition.

Many more players could shut in the coming months, whether in exchange for new larger capacities, according to Shandong government's plans to upgrade its refinery sector, or perhaps forced to do so, especially if they do not own rights to process imported crudes. And when they do, the scale of under-reported runs, which is due to the general tendency for errant refineries to report less, and the incidences of tax evasion will also probably wane.

The impact on runs at any one point in time though will not be significant, as closures will likely be a multiyear process. After all, the processing volumes of these at-risk refineries are small, and there is still spare capacity available – the NOCs operated at slightly less than 80% in 2020 versus close to their peaks/optimum of around 90%. This along with the new and larger refineries coming onstream will more than offset runs caused by closures. Currently, we forecast China's crude runs to increase by 719,000 b/d year on year in 2021 and the market share of independent refineries in Shandong could fall from 18.3% to 17.7%.