Spotlight on Shandong: Are China's independent refiners a shrinking market for global crude suppliers?

This is the last 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 independent refiners were the darling of oil suppliers for a few years, but some fear the market opportunity could shrink as capacity rationalization creeps in.

The rise of integrated petrochemical complexes already signals a change -- the independents were largely a spot market play, whereas the mega-refineries of Hengli Petrochemical (Dalian) and Zhejiang Petroleum & Chemical have long-term supply contracts with Middle East producers like Saudi Aramco.

So while Shandong drove trade flows of Russia's ESPO grade and Venezuelan crudes to China, the petrochemical complexes are making Saudi Arabia the country's top crude supplier, again.

This shift has benefited Aramco, which struggled to gain a foothold in Shandong earlier due to its reluctance to place barrels in the spot market and relax risk controls for counterparties. Its new petrochemical customers will help offset its saturated customer base in Europe and the US.

"The window has shut for trading companies to get good profit from China's small-scale independent refiners," a Singapore-based trader said.

Trading companies also burnt their fingers, first in 2018 when the central government cracked down on tax loopholes in Shandong, and subsequently in 2019 when refining margins fell into negative territory.

Many suppliers had open credit lines to Shandong's independents and when they defaulted, losses piled up at trading desks, heads rolled and credit limits were imposed.

The oil majors and traders who still do business in Shandong are those with a risk appetite, stronger risk management, local market expertise and long-term business strategy.

This includes Brazil's Petrobras, which tested new grades and uses local crude storage in Dongjiakou port to supply independent refineries, and Iraq's state-oil marketing company SOMO, which teamed up with state-run Zhenhua Oil to open direct marketing channels to independents.

Others include commodity trading houses like Trafigura and Vitol, oil majors with diversified portfolios like BP and Shell, and state-owned trader Unipec.

SMOKE-STACK INDUSTRIES

Traders exposed to Shandong still face risks.

In 2018, Shandong's private sector contributed just over half its GDP, and Shandong was the third-biggest provincial economy in China, according to S&P Global Ratings analyst Chang Li.

Li said many privately-owned enterprises in China's economically critical coastal province were now struggling to repay short-term debt, and Shandong-based companies recorded the highest default among all provinces in the first half of 2019.

"Shandong companies are ringing the alarm on liquidity," Li said, adding that declining industry fundamentals, entangled cross guarantees and ill-managed investments were triggering liquidity squeezes.

Cross-guarantees -- where companies under common ownership guarantee mutual obligations -- have become an endemic problem in Shandong.

For example, independent refiner Shandong Yuhuang Chemical failed to refinance its debt due to an unresolved cross guarantee with Hongye Chemical Group, prompting a Ratings downgrade in September.

The municipal government of Heze city, where Yuhuang Chemical is based, bought one of its subsidiaries for Yuan 2 billion ($283 million) to help with bond repayments and along with the provincial government also asked banks not to pull back outstanding loans.

Local governments have come to the aid of some Shandong companies deemed important, but only managed to provide temporary relief, Ratings said.

Shandong's economy is skewed toward gritty smoke-stack industries where companies are highly leveraged, and the plight of its private companies reflects China's wider challenge in transitioning to a higher value-added economy while managing high debt and slowing growth, Li said.

"Most recent Shandong distress cases involved companies in overcapacity sectors such as oil refining, petrochemicals, steel, aluminum and textiles," Li said, adding that slowing growth and tougher environmental regulations have strained their profitability.

Ratings expects challenging operating conditions in Shandong to continue and further strain the debt serviceability of these sectors over the next 12 months.

This is troubling news for Shandong's independent refiners, as trade finance accounts for around 90% of the working capital of a single refinery, traders told S&P Global Platts.

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 crude import quotas a boon or bane for China's independent refiners?

OFFSETTING TRADING RISK

During a recent tour, a Shandong refiner source noted: "When the tide recedes, you discover who is swimming naked."

They expected capacity rationalization to leave behind stronger companies with better financing mechanisms.

The refiners have little choice left, with state-run companies PetroChina and Unipec having stopped offering open credit since late 2018 amid tighter risk controls, and banks also pulling back.

One such company was Qingyuan Group (in photo), which operates two refineries totaling 8.2 million mt/year in Shandong.

Over July-August 2018, Qingyuan was saddled with four unsold crude cargoes and demurrage costs accumulated over 90 days due to refiners' cash flows drying up and inability to obtain additional timely credit.

It has since recovered, and in 2019 a group of lenders including Trafigura were working on a $1 billion credit line to Qingyuan. Trafigura had declined to comment on the transaction earlier this year.

Dongying-based refinery Tianhong Chemical also relied on oil major BP to secure 80%-90% of its crude feedstock.

"They [BP] offer 90 days open credit to us, which is really a relief for our cash flows," a refinery source said. Tianhong has a term contract with BP for 8 million barrels of initial supplies from mid-April 2019.

But this also came at a price -- the 90-day credit is at least 30-50 cents/b higher than a 30-day credit line, and an open credit line is even more costly, a trader said. BP did not immediately respond to queries.

Shandong's independents still offer a market opportunity, but discretion will matter.

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

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

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

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