Spotlight on Shandong: Are crude import quotas a boon or bane for China's independent refiners?

This is the fourth of a five-part special report on China's small independent refiners. S&P Global Platts conducted an extensive tour of the Shandong-based refining sector to gauge the direction it is headed and what it means for global oil markets. Shandong's independents have come a long way, having driven China's and global oil demand growth, but they also face new challenges as the country's overall refining sector evolves.

Shandong's refiners currently face many uncertainties -- China's economic slowdown, stagnating fuel markets, the light-heavy differentials challenging global refiners and the (hopefully positive) impact of IMO 2020 on refining margins.

Their immediate concern, however, is maintaining government-sanctioned quotas that are their biggest asset but also their Achilles' heel -- unused quotas affect future quota allocations so they have to be fully used up, regardless of market conditions.

This "refine first, think later" approach became hazardous when refining margins collapsed earlier this year and Shandong's independents were forced to choose between cutting run rates or accumulating losses.

As if this wasn't bad enough, the emergence of the Hengli, Zhejiang (under the Rongsheng Group) and Shenghong petrochemical hubs posed a new predicament.

The mega petrochemical complexes, which have economies of scale and a much higher pain threshold to maintain run rates in a tough market, are in a far better position to exhaust their crude quota allocations.

Hence, Shandong's small independents are now competing with the petrochemical hubs, and the first one to blink loses access to crude imports.

Refinery executives who spoke with S&P Global Platts said they were betting on the resale of unused quotas, which is unauthorized but prevalent, storage buffers and other mechanisms to keep utilization rates high, but the risk of losing out on quotas remains high.

WHY ARE CRUDE QUOTAS IMPORTANT?

Crude import crudes were instrumental in turning around Shandong's independent refining sector.

Refineries built by China's big four state-owned oil giants - Sinopec, PetroChina, CNOOC and Sinochem - always had access to crude oil imports, and everyone else needs to apply for a quota.

When Shandong's independent refineries were first awarded crude import quotas in 2015, it was a game changer. Until then, independents were low margin, low capacity plants called "teapots" forced to use domestic crude, crude resales from national oil companies or discarded fuel oil as feedstock.

With the help of quotas, by 2016, Shandong's independent refineries had helped drive up China's annual crude oil imports by 13% despite state-run refiners slowing imports. In 2017, the independents accounted for 80% of China's crude oil import growth and 30% of its refining capacity.

In 2016, NDRC awarded crude import quotas of 1.48 million b/d to 19 refineries, and today 45 refineries in China have quotas, out of which 34 are in Shandong.

Over January-October 2019, a total 3.19 million b/d of crude import quotas were awarded for all non-state refiners, more than the 2.81 million b/d for the whole of 2018.

Losing access to crude imports would decimate the product yield of Shandong's refineries and trigger shutdowns.

Also in the Spotlight on Shandong Series

• New petchem complexes threaten China's oldest refining cluster
• Independent refiners and the mystery of Asia's blended crudes
• China's refining overcapacity set to overwhelm petroleum product markets
• Are China's independent refiners a shrinking market for global crude suppliers?

THE GIFT THAT KEEPS ON GIVING, UNTIL IT DOESN'T

Shandong's refiners have resorted to reselling crude and unused crude quotas in the past to maintain full utilization. But even this strategy took a hit when margins collapsed earlier this year.

Although resales are illegal, they cover the needs of the independents that don't have quotas. The total quota ceiling for Shandong is around 106 million mt or 2.12 million b/d, including ChemChina's plants, while total refining capacity in the province is around 3.46 million b/d.

In 2017, when oil markets were healthy, the premium on reselling quotas was as high as Yuan 220/mt ($4.18/b), even more than the refining margin. This meant it was more profitable to resell than process the crude.

Over April-June this year, Asian refining margins fell due to oversupply.

Singapore hydroskimming margins based on Dubai crude were in negative territory for three consecutive months, falling to minus $1.57/b, while Tapis-based margins were at their lowest since 2014, IEA trade data showed.

The negative margins rippled through Shandong's refiners.

By June, premiums for reselling quotas hit rock bottom, as independents who had imported crude in bulk were desperate to offload inventories, while demurrage losses piled up.

At least one large independent refiner has shut its 3.5 million mt/year CDU and only operated its 2.3 million mt/year asphalt unit this year. Even the independent refiners without quotas suspended purchases, according to sources with Binyang Petrochemical and Hengrunde Petrochemical.

One independent refiner told Platts said that with bad margins, less than 80% of crude quotas will be utilized, and the remaining could be forfeited.

BEIJING'S POLICY NEXUS

In the longer term, quotas need to be viewed through the lens of China's macroeconomic policies.

In 2015, Shandong's opening up was backed by market reform and introducing competition for state-owned enterprises, which worked as the NOCs evolved their business strategies and shifted to high-value products.

The appetite for reform remains -- state planner NDRC is carving out a new state-run pipeline company from the NOCs.

Supply side reforms include encouraging private participation, such as the new petrochemical mega-refineries.

However, China's SOEs have found new favor under President Xi Jinping in strategic sectors like energy, and they will only get stronger and more efficient.

This is significant because NOCs had pushed for some policies to curtail small independent refiners like the crackdown on tax loopholes, and a lot will depend on how they leverage quotas to control competition and rationalize overcapacity.

Shandong's independents still have strong support from local governments, as they contribute to local economies, such as Dongying -- the biggest refining hub in Shandong.

This nexus of policy, economy and commerce will determine the future of Shandong's refineries.

Part Five of this series will look at the whether the Shandong refining sector is a shrinking market opportunity for global oil suppliers, their financial condition and evolving sources of trade finance.

-- Analyst Oceana Zhou, oceana.zhou@spglobal.com

-- Analyst Daisy Xu, daisy.xu@spglobal.com

-- Eric Yep, eric.yep@spglobal.com

-- Edited by Wendy Wells, wendy.wells@spglobal.com