Spotlight on Shandong: Independent refiners and the mystery of Asia's blended crudes

This is the second of a five-part special report on China's small independent refiners. Our team 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.

China's small independent refineries have driven a new trend in crude oil flows in 2019 -- record high imports of blended grades from Malaysia.

The trade flow in itself is unusual -- Malaysian oil production is on the decline, many of the blends contain grades from undisclosed origins and their suppliers are secretive about the exact composition.

The timing has also raised eyebrows -- it coincides with collapsing margins at Chinese independent refiners and the removal of favored Venezuelan and Iranian crudes from regular trading channels due to sanctions. New Malaysian blends are perfectly-timed substitutes to fill the gap.

Suppliers have tapped into the ability of Chinese independent refineries to adjust feedstocks at short notice and absorb spot market supply -- Shandong's independent refiners used to crack fuel oil and today process more than 30 grades of crude.

As a result, China's crude imports from Malaysia hit a record high of 1.38 million mt (326,000 b/d) in May and remained above the 1 million mt (250,000 b/d) mark for three consecutive months from May to July, data from General Administration of Customs showed.

Comparatively, in 2018, China's crude imports from Malaysia averaged just 175,000 b/d. Imports of blends did dip in August, but refiners expect trade flows to be sustained in coming months.

Malaysia started 2019 as China's 16th largest crude supplier, but by May it was the 8th largest. China's small-scale independents accounted for the bulk of these imports, touching a record high of around 310,000 b/d in May, a two-fold rise from last year.

Overall, crude oil imports by small independent refineries rose 11.3% year on year over January-September to 6.84 million mt, S&P Global Platts data showed.

Also in the Spotlight on Shandong Series

• New petchem complexes threaten China's oldest refining cluster
• China's refining overcapacity set to overwhelm petroleum product markets
• Are crude import quotas a boon or bane for China's independent refiners?
• Are China's independent refiners a shrinking market for global crude suppliers?

PERFECT TIMING

The Malaysian blends reflect the flexibility of Shandong's independent refiners in adapting to changing market conditions, driving new trade flows, and the markets' ingenuity in literally concocting new supply.

Like single-origin coffees or single-malt whiskies, single-origin crudes have unique characteristics, but these same qualities can constrain the number of refiners capable of processing them.

Asian refineries faced this predicament when US sanctions removed several key grades of Iranian and Venezuelan barrels from the market -- medium and heavy crudes that were baseload supply for many independent refiners due to

their discounted rates and profitable yield of middle distillates. This widened the light-heavy differential and preferred feedstock was sold at a premium.

Meanwhile, Shandong's independent refiners were going through a particularly tough phase: Their fortunes changed drastically between 2016 and 2019.

The independents went from taking their pick of high-quality crude feedstocks to scraping the bottom of the cheapest barrel in the market, hit by high oil prices, a government crackdown on tax loopholes, stiff competition from national oil companies, a slowing economy and low utilization rates.

Shandong's independents had been the marginal refiner in China's downstream sector for years, being the first to benefit from a market upturn. But they were also the first to hurt when markets soured.

When state-owned Sinopec, the refining benchmark for China, reported a 33.9% year-on-year drop in refining margins to $7.68/b in the first half 2019, the independents were in dire straits.

Sinopec enjoyed economies of scale with 5.91 million b/d of refining capacity, the largest in the world, allowing it to process various crudes to lower costs. But independents as small as 40,000 b/d did not have this luxury.

So when new compatible blends popped up in the market, with new names and heavy discounts, many independents lapped them up without thinking twice, several refiners who were offered these grades told Platts.

They said between January and July, only two cargoes of crudes actually produced in Malaysia arrived in China, Penara Blend and Wassana, while the remaining Malaysian barrels were blended from foreign crudes.

THE RISE OF MALAYSIAN BLENDS

Blending crudes from different origins in Malaysia is not new; trading house Mercuria has supplied Nemina Blend to ChemChina since at least 2017, Platts data showed.

Much of the blending happens offshore in Southeast Asian anchorages like Sungai Linggi or Tanjong Pelepas that are well known for ship-to-ship transfers.

But since April, blended crudes have found new buyers in at least eight independent refineries -- Hongrun Petrochemical, Luqing Petrochemical, Wantong Petrochemical, Shengxing Petrochemical, Chambroad Petrochemical and Qirun Petrochemical in Shandong province, Beifang Asphalt Fuel in Liaoning povince and Xinhai Chemical in Hebei province, traders said.

New blended crudes that hit the market up to September included Singma Blend, Pioneers Blend, Jazira Blend, Lenghun Blend and Singkep, traders said.

In July alone, at least two VLCCs of Singma Blend from Malaysia, with an API gravity of 16.3-16.5 and 2.78% sulfur content, were delivered to three independent refineries, and this trade flow continues, a trader said.

However, a few things about the blended crudes stood out. Some were suspiciously similar to known Venezuelan grades.

"Singma crude looked a lot like Venezuela's Merey crude, judging from specifications," a trader said.

Before US sanctions hit, China's small independent refiners were among the largest buyers of Venezuela's heavy Merey crude and processed 6.19 million mt of the grade in 2018, according to data provider JLC. This accounted for 37.2% of China's imports from Venezuela in 2018, data showed.

Traders said quality specifications of the blends could also vary widely, and were misleading as the actual yields differed from the assay -- a document that details quality specs. For instance, the API gravity for Nemina Light cargoes that arrived in April-July ranged from 34.7 to 46.94, a Platts' survey of refiners showed.

Traders attributed the variations to the wide pool of constituent crudes from West Africa, the Middle East, Venezuela and Iran, depending on what was most economic or what ship was passing by.

The versatility of the Shandong independents will continue to drive new trade flows -- and underpin their survival.

Part Three of this series will look at how Shandong's independent refiners will fare as China's refining overcapacity spills over to Asia's refined product markets.

-- 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