Coronavirus Stymies China’s Private Oil Refiners – Analysis

By Michael Lelyveld

Turmoil is rising in China’s oil industry as the consequences of the coronavirus epidemic threaten independent refiners and their sources of finance.

The sudden plunge in economic activity in February stunned China’s independent refiners, known as teapots, after domestic fuel sales froze and oil demand dropped by an estimated 3.2 million barrels per day.

The refineries concentrated in coastal Shandong province slashed production runs in response, but not enough to keep up with the steep slide in demand.

High inventories have forced the teapots to boost fuel exports in a glutted market, leading to lower prices and losses.

The research arm of state-owned China National Petroleum Corp. (CNPC) estimates that first-quarter demand for oil products this year will fall 35.7 percent from a year earlier, Reuters reported.

On Feb. 24, the news agency said that international banks had suspended U.S. $600 million (4.1 billion yuan) in credit lines to at least three private refiners due to “rising concerns about overall industrial defaults.”

The three refiners account for a combined 240,000 barrels of oil per day, based on their government-issued annual import quotas of 12 million metric tons, Reuters said.

The impact may be symptomatic of larger troubles for the industry and the economy as the government tries to restore production and transport in regions where COVID-19 infections have been kept at relatively low levels.

On Feb. 27, reports surfaced that Hontop Energy, a Singapore-based oil buyer for private refiner Shandong Tianhong Chemical Co., had gone into receivership earlier in the month. The Hontop shutdown sounded an alarm for the industry that handles about 20 percent of China’s oil imports.

“Its demise brings focus onto the financial health of many of China’s private refiners, … which have built up massive debt loads to modernize infrastructure and procure crude on a global scale,” Bloomberg News said.

But in another report this week, Bloomberg said the refiners had again raised production rates more than 3 percent by the end of last month in response to the partial resumption of economic activity.

Overcapacity, poor margins

Even before the current crisis, the teapot refiners have struggled with overcapacity and poor margins after opening new plants.

Last year, profits in the refining sector dropped 42 percent, the China Petroleum and Chemical Industry Federation said, citing overcapacity and declining demand.

“Many of the teapots are already on a credit red flag list of banks in Singapore,” said Michael Meidan, director of the China Energy Program at the Oxford Institute of Energy Studies, quoted by Bloomberg.

“The virus has certainly tightened cash flows and exacerbated banks’ concerns,” Meidan said.

Despite the buildup of pressures, the refiners arguably made matters worse by trying to take advantage of lower crude prices and seeking short-term profits.

On Feb. 14, Bloomberg reported that several teapots had surprised the market by going on a buying spree in January and snapping up oil cargoes from Russia, Angola, and Gabon.

“Until recently, this corner of the industry appeared to be doing everything to avoid buying crude, including cutting processing rates,” the report said.

The refiners appeared to be positioning themselves for an economic recovery, a prospect that may prove to be premature.

“The spree is probably a sign that the refiners … are getting ready for an eventual rebound in demand, taking advantage of the slump in crude prices to buy cheaply,” Bloomberg said, citing comments from traders.

The rapid spread of the coronavirus outside China could make the buying spree a costly bet.

Philip Andrews-Speed, senior principal fellow at the National University of Singapore’s Energy Studies Institute, said the trouble for the teapots will put them at greater disadvantage to the national oil companies (NOCs) like CNPC that dominate the industry.

“I guess the teapots are opportunists. They saw low prices and thought the epidemic and demand would recover soon, and so ‘bought low.’ But ‘low’ was not the bottom, so they are in trouble,” Andrews-Speed said.

“Conversely, the NOCs with their soft budgetary constraints and ability to cross-subsidize can keep going regardless,” he said.

“If this continues, the teapots, or some of them, will disappear and the NOCs will be even more dominant. So much for competition,” Andrews-Speed said.

Unfavorable economic outlook

The economic outlook for the teapots is far from favorable.

“With the jump in virus cases overseas, there is a growing risk of a protracted downturn in foreign demand,” said senior China economist Julian Evans-Pritchard in a Capital Economics report.

“The likelihood of a V-shaped recovery in the coming months is falling fast,” Evans-Pritchard said.

While China’s government and state media continue to make the case for a rapid rebound, economic indicators have sunk to historic lows.

The government’s own purchasing managers’ index (PMI) for manufacturing, compiled by the National Bureau of Statistics (NBS), plummeted to 35.7 last month from 50.0 in January.

A reading of 50 marks the tipping point between expansion and contraction. In January, the index fell just 0.2 points from a month before.

The official non-manufacturing PMI also tanked, dropping to 29.6 in February from 54.1 a month earlier.

A private manufacturing PMI survey conducted by Caixin Global Ltd. fell from 51.1 in January to 40.3 last month, the lowest reading since the survey started in 2004.

The troubles facing teapot refiners are likely to be symptomatic of problems for other overcapacity industries such as steel, coal, and coal-fired power generation as China struggles to resume economic growth.

‘A vigorous revival’

While the first quarter has largely been written off, Chinese industry officials have issued optimistic statements about a surging second-quarter recovery.

On Feb. 25, the official English-language China Daily acknowledged “a rough time” for the steel industry due to rising inventories and falling prices, the same conditions afflicting the refining industry.

But Luo Tiejun, vice chairman of the China Iron and Steel Industry Association, voiced confidence in a second-quarter recovery.

“Many steel companies will slash output as inventories pile up, but a vigorous revival of market demand in the second quarter of this year is expected, given that the Chinese authorities have rolled out a slew of measures to stabilize economic growth and the epidemic will hopefully taper off,” Luo said.

First-quarter losses are likely to inflict heavy damage on the industry, however. China top steel producer, China Baowu Steel Group, expects a first-quarter loss of U.S. $428 million (3 billion yuan), The Wall Street Journal reported.

In the longer term, the epidemic may renew the debate over China’s production overcapacity and investment in plants that will soon become “stranded assets,” unable to pay for themselves.

A 2017 paper by the University of Oxford Smith School of Enterprise and the Environment warned that the losses from halting all of China’s unneeded coal-fired power plants by 2021 would reach nearly 4.5 trillion yuan (U.S. $646 billion).

Last year, the Global Energy Monitor, a U.S.-based research group, made a similar argument about the future obsolescence of liquefied natural gas (LNG) infrastructure as the cost of renewable energy sources comes down.

China has invested heavily in nearly two dozen LNG port terminals with storage facilities and pipelines on the strength of double-digit import growth in recent years.

But growth declined sharply last year and importers have been turning away contracted cargoes since then. The epidemic has devastated demand and driven LNG prices to record lows, raising the risk that China’s infrastructure investment may also turn into stranded assets.